Portfolio Engineering

Traditional money managers typically fall in to one of two categories: Active or Passive.

Active Management

Investors that attempt to identify the very "best" stocks to own amongst the thousands of publicly traded stocks are collectively referred to as Active Managers. Such investors believe that they can "cherry-pick" the winners by carefully analyzing financial data, interviewing company management, and making forecasts. Because their process is more of an art than a science, they typically make only vague references to the specific characteristics that identify their investment style.

While it makes intuitive sense that a mutual fund manager with a Harvard degree would be intelligent enough to identify the best stocks to own in a portfolio, a mountain of academic and empirical evidence refutes this notion. As far back as 1965, Warren Buffet himself made this observation:

"It is remarkable that such a large majority of professional investors find it so difficult to match the returns of the stock market itself. The most celebrated individual investor of our time, Warren E. Buffet, wrote in January 1965 on the puzzle of the tendency of professional investors to under perform the market. Mr. Buffet mused:

'Why in the world does this happen to very intelligent managements working with (1) bright, energetic staff people, (2) virtually unlimited resources, (3) the most extensive business contacts, and (4) literally centuries of aggregate investment experience?'

Excerpt from The Dividend Investor, Harvey C. Knowles 111 & Damon H. Petty, 1992

In fact, depending on the study period, as many as 85% of all Active Managers have failed to match the returns of a broadly diversified benchmark index. Active Managers defend their approach by trumpeting the success of the minority that has managed to deliver superior returns. However, statistically speaking, there are far too few managers that have "beaten the market" than one would expect simply by random chance.

Passive Management

Because the collective track record of Active money managers does not produce any evidence that this method can consistently out-perform the broad market, another approach to investing has evolved. Traditional Passive Management attempts to simply passively mimic the performance of generally accepted commercial indexes such as the S&P 500 (large company stocks), Russell 2000 (small company stocks), etc. Passive Investors believe that the best an investor can hope for is broad exposure to these indexes to perform right in line with "the market".

The problem with pegging performance to commercial indexes is that many of these commercial indexes are created haphazardly. The S&P 500 Index, for example, is generally regarded worldwide as the proxy for US large cap stocks. However, Standard and Poor's is simply a publishing company. The editors at Standard and Poor's meet periodically and, using a very ambiguous set of rules, assign 500 large companies to this S&P 500 index. Their goal is to simply assemble a group of 500 companies that collectively provide broad representation of US Large Company stocks. The only (albeit subjective) criterion for inclusion in the S&P 500 is some vague notion of "bigness". A company automatically satisfies all of the entry requirements of the S&P 500 list simply by being large.

The Best of Both Worlds: Portfolio Engineering

Given the historical evidence that demonstrates the futility of Active Management, many investors resign themselves to passively following a Passive indexing strategy. However, as engineers, we set out to identify quantifiable characteristics other than "bigness" which would lead to higher expected returns than those of the commercial indices. Our approach, Portfolio Engineering, combines the fundamental philosophy of index investing with a quantitative security selection process.

The end result is a set of low cost, quantitatively managed, diversified portfolios that offer calibrated exposure to specific dimensions of risk in the markets. These un-priced risks give our portfolios higher expected returns than traditional passive strategies. Our job is to combine these risk factors into diversified institutional quality portfolios that match our individual clients' goals and risk tolerance.

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