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Prudential Tries Novel Diversification Tactic

Prudential Investments of Newark, N.J., has introduced three unusual sector funds that mix enhanced index investing with active management. The funds, introduced May 26, are the Prudential Technology Fund, the Prudential Health Sciences Fund and the Prudential Financial Services Fund.

Fifty percent of the assets in each fund will be managed as enhanced index funds and 50 percent will be actively managed. The index in each fund contains stocks selected from the Standard & Poor's SuperComposite 1500 Index, which combines the S&P 500, S&P 400 and S&P 600 indices and represents 87 percent of the total market capitalization in the U.S.

The firm decided to offer these funds in part because of the "phenomenal attractiveness of index funds in the last two years," said Neil McGuinness, executive vice president at Prudential. In addition, Prudential believes that the technology, health care and financial services industries are good picks because they "are driving the economy and make up over half of the U.S. market," he said.

Yet despite these three sectors' promise, "sector funds are a little more volatile" than other types of mutual funds, McGuinness said. Therefore, Prudential decided to place half of each fund's assets in an enhanced index portfolio "to give investors broader market participation," he said.

"We thought that clients would be more comfortable moving into these sectors if we could limit their downside risk by giving them greater market participation through an enhanced index," McGuinness said. "The hybrid design gives them a feeling of comfort. If they put money in the Prudential Technology Fund, they know it's not a wild and crazy fund, but one that offers them broad participation in all types of stocks in the technology sector."

Even so, the portfolio mangers of the three funds will be allowed to invest more than five percent of assets in the securities of any one issuer. Also, the portfolio managers will be permitted to duplicate investments between the actively-managed and enhanced-index portions of their portfolios.

"We are willing to let overt over-allocation to a stock happen if the portfolio manger is really hot on a stock," McGuinness said.

Industry observers wonder whether the possibility of concentrated exposure in just a few stocks could run counter to Prudential's claim that these hybrid sector funds will be more diversified than other sector funds.

"I think it's an attempt from a marketing approach to get people into a sector fund, rather than a clever and innovative investment approach," said Burton Greenwald, president of B.J. Greenwald & Associates of Philadelphia. "Sectors are cyclical. Even if you are in a mixture of index and actively-managed styles, you are still in a sector and still exposed to volatility."

Geoff Bobroff, president of Bobroff Consulting, a mutual fund research and consulting firm of East Greenwich, R.I., agrees that such a hybrid sector fund may not guarantee diversification.

"The portfolio manager will probably pick many of the stocks in the index, and that means you make a bigger bet," said Bobroff.

McGuinness dismissed these criticisms. Historically, either indexes or active management have dominated at any given time, he said. A fund that takes both approaches at once gives investors a likely chance of being in the dominant approach at all times, he said.

Prudential chose the technology, health sciences and financial sectors because these are areas of the economy poised for strong and steady growth, said McGuinness.

Prudential is apparently the first to introduce funds that combine both enhanced indexing and active management of securities concentrating in a sector, both Bobroff and Greenwald said. However, TIAA-CREF of New York operates all its funds as a combination of these two strategies but does not concentrate in particular sectors for the managed portion of any of its funds, said Greenwald.

Prudential is marketing these funds to "higher net-worth investors who have some money that they are willing to take a little more risk with," McGuinness said.

Prudential is currently distributing the funds through its 6,200 brokers and will later make the products available to its 8,200 insurance agents as well.

To raise awareness of the new funds and create excitement about them, Prudential's portfolio mangers are meeting nationwide with brokers, field managers and registered investment advisors. Prudential's analysts, portfolio managers and marketing staff are also hosting conference and video-conference calls. Prudential has also created a videotape of Prudential analysts discussing the promise of the three sectors.

Prudential is also using the indication of interest' technique it used successfully last year to launch its Focus 20/20 fund. According to this approach, Prudential's hybrid sector funds will initially be sold for only 30 days through the end of June. They will then be closed for a two-month cooling-off period and reopened in the beginning of September. McGuinness said this creates an aura of mystique and excitement, much like an initial public offering.

Within eight business days of introducing the three funds on May 26, Prudential had already attracted $134 million to the three funds. When Prudential offered its Focus 20/20 using this marketing technique, the firm raised $500 million in assets in the first 30 days.

The launch of Focus 20/20 was Prudential's most successful launch of a mutual fund ever and the firm is hoping to enjoy equal success with its new hybrid sector funds, said McGuinness.