John Serrapere is known as The Active Indexer.

The title was bestowed on the longtime analyst after he started contributing research reports to the Journal of Indexes in 2003.

"I don't have an axe to grind in terms of classifying my investing strategy," said the investment strategist for Foster Holdings Inc. in Pittsburgh.

Serrapere takes a distinctly contrarian approach to index investing. It's an independent view that at times has brought him harsh words from other money managers and advisors.

"Excessive hubris and ego aren't traits that serve investors very well over the long run," said Serrapere during a recent discussion. "The markets keep even the best humble. It's important to realize there's no silver bullet in investing."

He has the credentials to walk among some of the biggest names in the business. A case could be made that Serrapere was instrumental in helping to shape Rydex's product strategy for indexing and alternative investments earlier this decade when he served as a principal at Rydex Leveraged Hedges LLC.

And his research into what's now called fundamental indexing puts him in many ways in the same league as industry leaders such as Research Affiliates' Rob Arnott.

But throughout his long career, Serrapere has stayed out of the limelight. He prefers to work on the fringes, putting ideas and pet projects in the forefront. These days, he's working on a new consulting venture, Arrow Insights LLC, which is trying to advance a host of new alternative indexing strategies.

Eclectic Approach 

It isn't easy to classify Serrapere's method. He considers himself somewhere between a fundamental indexer and an active fund sampler. He takes a top-down approach, looking at expected long-term returns of passively investing in various stock and bond indexes.

In 1999, his research led him to conclude that stock returns would fall into the 3.5%-to-5% range over the next 20 years. Serrapere also wrote that specific bond categories could produce anywhere from 6%-to-8% gains in that same period.

Of course, that was way ahead of the curve. Today, strategists are just starting to revise down their estimates for most equity categories over the longer term.

"I published a series of articles for Corporate Finance Review from 1997 through early 2000," said Serrapere. "But nobody was reading except for a bunch of real finance geeks."

The magazine was owned by Thomson, the big data provider. In late 1999, as stock markets were peaking, a well-known chief investment officer at a major insurance company accused him of trying to raise a ruckus to gain fame.

"I got terribly frustrated and almost quit the whole business," said Serrapere. "I wasn't trying to be a hero. I was just saying that this is a crazy world."

A tenet of his investing philosophy is to look at a basket of seven or eight fundamental valuations. Those include price-to-earnings, free cash flow, price-to-book and dividend yields.

"It's very similar to how Rob Arnott invests," said Serrapere. "In fact, when he came out with his fundamental indexes, I was right behind him at Rydex. If I could've convinced as many people and assembled as big of an army as Rob formed, we'd have been right there."

He adds: "In fact, if you look at the recent Barron's article on Arnott, I'm doing the same thing. He's going into TIPS, corporate bonds, emerging markets and foreign debt. Those are the same things I'm moving into."

Half of his portfolio is based on fundamentals using index-based products. "Those enable me to overlay technical analysis on top of the fundamentals without worrying about company-specific risk and what other managers are doing," said Serrapere.

Fundamental valuations lead him to what corners of the market appear most attractive. Then, he applies technical factors to determine when to enter long positions and also to determine how much of a bet to make on a particular fund at any given time.

"Where I get nimble and use technical analysis the most is on the short side," said Serrapere.

He never wants to take more than a 170% gross portfolio position. That means if he ever goes 100% long, he'll never take short positions of more than 70% at any given time. "I did some backtesting and evaluated hedge fund managers over the years. Once you go over that level, your volatility gets too out of hand," said Serrapere.

Nor will he take less than a minimum gross position of 70% in portfolios, he adds. That means Serrapere will go into "hiding" in a 30% cash position at times. "When I've really got a lot of conviction about the market, I'll go to 170% long-short," he said. "Right now, I'm at 145% gross: 40% short and 105% long."

For the first time ever, Serrapere's shorting Treasuries. "It's not a huge position, but I'm slightly shorting an ETF," he said, adding that he's using the UltraShort Lehman 20+ Treasury ProShares ETF (NYSEArca: TBT).

In the next 20 years, Serrapere expects stocks to earn 7%-9%. And in the next 10 years, he cautions that Treasuries could actually produce negative returns.

Corporate bonds, however, seem to be headed in an entirely different direction, says Serrapere.

"A few weeks ago, corporate bonds were being priced for a depression with expectations that default rates would soar," he said. "But that's highly unlikely. Basically, I see that by combining high-yield and investment-grade corporate bonds in a portfolio, you have an opportunity to earn equitylike returns over the next 10 years."

In times of extreme volatility, Serrapere says he tends to invest in funds with a three- to six-month time horizon. "The last three months have been the most volatile period ever in the market. It has been equal to about a 70% annualized standard deviation rate," he said.

Serrapere tries to keep annualized turnover to around 50%, he says. But market fluctuations in the past several months could boost that rate by threefold.

Choppy Trends

"Positions I expected to produce returns in a month or two are moving so violently now that entry and exit points—especially on short positions—are taking a much more nimble form," said Serrapere. "My technical overlays are telling me that trends remain very choppy."

Valuations are at the point, though, where he's looking to take longer-term positions. "The way I'd invest going forward is to accumulate long positions and not to trade those. But I'm going to hedge them, staying very nimble," said Serrapere.

He added: "I'm looking at some funds now that could be held for years. The market has gotten to a point where everything's so cheaply valued, plenty of opportunities are available."

Serrapere admits that active trading presents a high hurdle for investors to overcome in terms of transaction costs. "If you're not consistently able to achieve high absolute returns, it's not worth being an active indexer," he said. "The only way it makes sense is if you can make hedge-fund-like returns over time. But I think you can beat hedge funds using index funds simply based on costs alone."

With all of the options ETFs are providing, active indexing can now be used as a strategy to replace hedge funds in portfolios, adds Serrapere. "Three years ago, I couldn't be doing what I'm doing now. ETFs have given us all the tools we need to be more active. You don't need a hedge fund manager anymore to build portfolios implementing long- and short-term strategies," he said.

Murray Coleman is managing editor at IndexUniverse.com. He welcomes comments and suggestions for future columns at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .