Decision-Making Process

Optimal Diversification

Individual security weights are driven by combining our notion of future profits and our forecast of risk, the ultimate process by which we create portfolios.
We employ commonsense rules to reduce risk — lots of stocks, sector-neutrality (13 sectors), and controlled and limited stock-specific bets. In our managed-volatility strategy where there is no optimization benchmark, sector weights are driven by our attempt to maximize expected return while minimizing total volatility. In addition, we consider six other factors:

Industries — Within sectors, 34 industry groups come into play (exposure is controlled but is not neutral).

Market Cap — Capitalization size is tethered within each sector.

Fundamental Characteristics — Growth, value, and market sensitivity are used to measure and temper fundamental risk.

Interest-Rate Sensitivity — Stocks’ sensitivity to changes in the 10-year Treasury rate matter.

Return Cluster Groups — Diversification among statistical groups reflecting long-term price movements is our aim.

Covariance — Individual stock-by-stock covariance is considered on a sector basis, measured by residual returns over the prior 500 trading days after extracting all of the influence of the other risk and diversification factors.

The most important determinant of a security’s weight (including negative weights on the short side) is our forecast of future profits. Although we seek to squeeze out every penny of excess return, we also seek to balance multi-faceted risk.