Q:  How does this fund differ from its peers? A : This fund is different from our peers in that it is not a stock picker’s fund. It is more focused on beta management and managing risk than alpha management and generating excess return to market averages. Beta is much more powerful than alpha and if you do not manage it well, it does not matter what your alpha is. We are trying to manage global equity exposures. We put interesting themes into the portfolio that we think most people have not thought about. My background is what led me to take this approach. I was with Merrill Lynch for over 20 years. My final position was as the firm’s Chief Investment Strategist. Before that I was the Chief U.S. Strategist. Before that I was the Chief Quantitative Strategist. I became known for a combination of top down macro analysis combined with bottom up quantitative stock selection. We are the polar opposite of a traditional alpha manager that pays a lot of attention to stock picking and takes concentrated bets. We have over 300 names in our portfolio. No one stock has any chance to dominate the portfolio. We do not care about stock picking; we only care about getting beta exposures. This dates back to the original concept of core and satellite funds. The core funds are supposed to be the management of the key macro exposures (beta management) and the satellite funds are supposed to be your more extreme stock picks (alpha management). What has happened to most funds is they are a blend of the two. They are neither alpha funds nor beta funds. They hold too many stocks to be an alpha manager but have too much stock exposure to be a beta manager. Q:  What is your investment philosophy? A : We believe in taking a different, more macro-based approach. A lot of money managers talk about the macro economy and talk about individual stocks as if they are experts in everything. We know what we know and we know what we do not know. We know the macro side of investing but we do not know the differences between individual stocks. We are not going to spend our time doing that. We are going to spend our time looking at the macro exposures and managing them successfully. This is a global equity fund so we have indicators all over the world that we examine, such as liquidity, inflation, corporate profit, sentiment, valuation, earning surprises, earnings revisions, currencies, yield curves, et cetera. We follow all these indicators and then we look for gaps between perception and reality. We try to use as much data as we can possibly get. We want to look at as many cycles as possible. The larger your sample size the more reliable the conclusion. There is not any one situation to which we always refer. For us, it is gathering as much data as we can and being as dispassionate as one can be. We look at profit cycles regardless of the microcosm or macrocosm of the global markets. We may look at the profit cycle within a sector, or a country, or within a region, or around the world, depending on what we are trying to understand. We do not try to define the length of the cycle. We are not looking at the absolutes of good or bad, we look for better or worse. The indicators try to forecast profit cycles. We then follow those indicators and will do so until the indicators begin to start to change. As they begin to show more caution, we will then change our strategy, get more cautious ourselves, and we will stay cautious until the indicators begin to turn up again. Q:  What is your investment process? A : Our investment committee meets at least once a week. If there is more volatility and there is a need to do so then we will meet more often. Although the fund is only three years old, the committee is a very experienced bunch. The least experienced person on the investment team has 12 years of experience. The most experienced person has over 40 years of experience. We start every one of these meetings by looking at what has happened. We review our performance. We look at our positions. We look how our positions are drifting. We decide if we want to take appropriate actions. Then we will shift and talk about what is going to happen. From there, it becomes a forward-looking meeting. The forward-looking meeting begins with a review of the most important indicators that have been updated since our last meeting and we examine what has changed. Then we try to assess if what is changing is meaningful. We do some of it statistically but we also use judgment in terms of whether the indicators are changing enough to warrant some kind of strategy change within the mutual fund. Assuming we have to make a change, we then decide if it is a big or small change, we examine any potentially conflicting views, whether the signals are broad enough to tell us to do a major rebalance of the portfolio, or if those indicators are telling us we just have to tweak or eliminate one of our themes. Assuming we have to tweak our approach, we do some quantitative screens to come up with a basket of stocks that we think adequately represents our views about the specific theme. We then quantitatively optimize that mini-portfolio to try and get a risk-efficient, minimum risk portfolio of the stocks we want to add to the existing funds. We will then trade that basket and insert it into the fund. If the indicators changed enough to warrant a major rebalance of the fund, which may happen once or twice a year, all the exposures and themes are reset to what we are trying to accomplish. If we want certain things to occur within the portfolio, we will re-optimize the entire fund. We try to look for the minimum risk portfolio that will get us the themes that we like. We look for gaps between perception and reality, for example, we noticed several years ago the difference between how investors perceived the emerging markest and what was actually happening. We saw profit indicators beginning to erode. We saw valuation indicators that were extended and we saw sentiment that was very bullish on emerging markets. The leading indicators of the emerging market profit cycles began to slow down, yet sentiment got more bullish. That to us was a clear sign to get out. Q:  How do you look for gaps between perception and reality? A : Another way to think about the gap between perception and reality is that you want to be the provider of scarce capital. You want to be the one banker in a town with a thousand borrowers. By definition your return on capital will be very high. If there are a thousand bankers and only one borrower, the borrower is going to make out like a bandit. About three years ago when we started the fund, one of our big themes was that we had to look for areas of the global economy that were starved for capital.. We could not quite figure out where it was and then we began to look at some of the lending data and we saw that smaller companies in the U.S. were being cut off from the capital markets. We decided this was where we had to go. If you think about an early cycle environment you have monetary and fiscal policy at your back and fundamentals begin to improve. We had monetary and fiscal policy at our back big time, the fundamentals were beginning to improve, but nobody believed it. The script says when fundamentals improve you should buy high-beta stocks. On top of that we found that high-beta stocks were getting cut off from the financial markets. They could not get capital so we wanted to be the provider of scarce capital. We took major positions in the fund in U.S. small cap companies. We have now gone a step further and about a year and a half ago we added to a second small cap theme, which was small cap domestic industrial and manufacturing companies—what we call the American Industrial Renaissance. We saw the fundamentals improve and we noticed that nobody wanted to invest in them, nobody want to lend to them, but they were beginning to gain market share. We think this is one of the best growth stories in the world, but a lot of people still do not believe it. They cannot fathom that small industrial companies in the U.S. are gaining market share. We measure the market share by using data from one of the organizations that lobbies for the small industrial companies in Washington, D.C. The irony is that the lobbying organization is telling Washington how horrible it is for small manufacturing companies is in the U.S. when their own data shows the companies are gaining market share. We tried to figure out why they are so bearish and then we realized they are lobbyists. Lobbyists have to bearish. If you go to Washington and say everything is good then Washington will not care. If you say everything is horrible then Washington will listen. We do research and always look at the source’s methodology. We try to look at various aspects of their data set. We scrub down the data to see what is going on and then we do our own quantitative screens for companies that meet our criteria that we want to include.. For the American Industrial Renaissance, we found some companies were creeping in that did not meet our goal so we sat down and redesigned the screen and came up with the universe of 40 or 50 names. Then, we optimized that portfolio to try and get a minimum risk portfolio and then bought the entire basket of 40 or 50 names and put that right into the mutual fund. Q:  At what level of income statement you look for earnings? A : In the U.S. we use GAAP-reported earnings, which is the most volatile measure of earnings you can find. Companies would prefer that investors not value them on GAAP-reported earnings because GAAP data skew the analysis most in the investor’s favor. We want to measure earnings that have the maximum amount of cyclicality in it. As you move up the income statement you will decrease the cyclicality. Q:  How do you construct portfolio and balance risks? A : It is not hard to outperform the market. What is hard is outperforming the market with less risk. Of the 60 or so strategies that we tested at Merrill Lynch, maybe three or four outperformed the market with less risk. Portfolio construction and balancing risk are very important to us. It is one of the reasons why when we put a new theme into a portfolio we always use an optimizer to get a minimum risk portfolio. This simply means that companies with higher volatility will get lower weights and companies with lower volatility will get higher weights. When we do a major rebalance of the fund we will take the entire fund and put it back into our optimizer to reweight the stocks to try and get the risk averse weighting back into the portfolio. We have themes and we set targets for the themes. The theme may be a region or it may be the American Industrial Renaissance. It could be anything but we will set a target on it. We see how the optimization process works and what it does to our theme and what are the other things that are cropping up. It is a very laborious and often tedious process. We refuse to accept what the black box says without understanding why it is saying it. We insist on understanding everything about why the optimizer is doing what it is doing. If we cannot understand something we will not invest in that portfolio. I come from a quantitative background but I refuse to simply accept what a model says. I have to understand why. There has to be an economic reason why a model comes up with the results and if we cannot understand the economic reason we are not going to invest there. We spend an inordinate amount of time trying to understand the results. Q:  How many holdings do you have and what is your selection process? A : For the sake of diversification we do not allow any one company to dominate the fund. We have over 350 names in the portfolio and that is done on purpose because we are not stock pickers. If we are not stock pickers we do not want stock exposure. In the history of the fund, over 80% of the risk that we have taken has been macro-oriented risk, which we understand. We do not want a lot of company specific issues creeping into this portfolio. We do not care about the individual stock performance. We want the themes, the sectors, and the countries to dominate the profile. From that respect, diversification is very important to us to get rid of that company specific risk. One of the reasons we follow so many indicators is that a lot of them are corroborating evidence for the other indicators. We use completely different sources, completely different data sets and they may even originate in different parts of the world. We are always looking for corroborating evidence because if you only follow one indicator it will work until it does not work. We want to make sure we are not blindly following an indicator over a cliff. We have found with most tested indicators, people make excuses not to look at the signals. An example is an inverted yield curve. This is a classic kiss of death indicator. When it inverted in 2006 and 2007 people said that it was only inverting for technical reasons, as though there had never been a technical reason for the yield curve to invert in prior cycles. Recently India had an inverted yield curve and we thought that was strange. In an environment where most yield curves around the world are positively sloped, all of a sudden India’s is inverted. We made sure we had no exposure to India and now we see the Indian stock market has not done well. When we first started taking defensive positions people thought that we were insane. Of course, we are paranoid an indicator may not work and therefore we use the corroborating evidence technique. Generally, what we have found is that tested indicators tend to work but people often do not follow them anymore. That is difficult for us emotionally too. You may have a theme that you are working on and then all of a sudden the indicator says it is time to get out. Human nature incorrectly tells us that the indicator must be wrong because the theme is working so well. That is why we have a committee, and don’t depend on one person’s emotions. The most unique aspect of this fund is that we do very different things. We are not index huggers. We take very sizeable positions from time to time. I do not think you will find many global equity funds in the last two and half years or so that have had less than 2% in emerging markets. We try very hard to take meaningful positions within the portfolio. We are measured against the MSCI All Country World Index. Q:  How do you define and manage risk? A : There is an academic definition of risk and there is a practical definition of risk. The academic definition of risk is volatility. The practical definition of risk, and the way people actually act, is some element of a loss. It may be losing money. It may be falling short of some benchmark. Nobody cares about volatility until you fall below whatever the threshold return is that makes you upset. Although we use volatility in a lot of things we do, this is not how we measure risk. We define it as a probability of a loss or a severe loss, depending on the analysis that we do. In our optimizations we use the traditional academic definitions of risk but when we are doing certain analyses we will use probability of a loss or severe loss.