Q:  What are the founding principles of your investment philosophy? A : Our philosophy is based on our conviction that it pays to think about the concept of risk-adjusted return. There are actually a couple of reasons why that is important. First, from a long term compound return perspective there is a real arithmetic reason to focus on risk-adjusted returns as opposed to beating the benchmarks or peers. Steadier returns compound more efficiently. The other reason is almost a corollary of the observation that so much of the investment world is caught up in the pursuit of higher relative return, that it leaves behind some opportunities for risk-adjusted return that we think are underexploited. For us, that is an attractive proposition and we want to build our whole strategy around the idea of risk-adjusted return. One of three main ways to do that is across the asset classes, or by focusing on the allocation of risk as opposed to the allocation of money or asset. The second way we think about pursuing risk-adjusted returns is within the asset classes. And finally, the third way we think of delivering risk-adjusted return is across time meaning we pay a great deal of attention to the risk taking conditions prevailing in the market. On a dynamic basis we try to take our risk when the conditions are accommodating to taking good investment risk. And if volatility kicks up or vulnerabilities present themselves, then we generally take a lower level of risk than normal. So our philosophy is that we want to blend those three perspectives across asset classes, securities and time in a strategy that delivers superior risk-adjusted returns. Q:  Would you elaborate on your “risk parity” concept? A : Risk parity is a term that refers to a strict balancing of the risk across four categories – equity, credit, interest rate, and inflation sensitive. It describes the portfolio construction methodology and seeks to strictly equalize the risk contributions that each of those four categories make. There are a couple of ways of accomplishing risk parity. One is by shrinking the weighting in the portfolio of higher volatility holdings like stocks or commodities to diminish their impact until it is equivalent to the impact that lower volatility assets make. The other way to think about it is rather than shrinking our allocation to the high volatility asset classes, we use leverage to amplify the contribution that lower volatility holdings make. The term “risk parity” generally refers to the latter. The portfolios that use leverage to redistribute risks away from the dominance of high volatility holdings and in the direction of raising the proportion of prominence of low volatility holdings are often referred to as “risk parity” strategies. Q:  What is your investment strategy? A : First of all, with our investment process we seek to design a policy portfolio at the asset class level. Here, we specifically target about half of our risk coming from our equity holdings and the other half of our risk coming from the other three categories; interest rate, credit and inflation-sensitive. The reason why we do not look to strictly equalize those contributions is because we have higher confidence in the equity risk premium and at a practical level, equalizing volatility contributions would require substantially more leverage than we use. We make a fairly conservative use of these leveraged securities to accomplish our policy portfolio. That constitutes step one in our investment process. The second step identifies and implements the appropriate strategies within the various asset classes. In other words, we figure out the best way for us to get exposure to each asset class, like U.S. stocks, high yield bonds, or emerging market stocks. We have many different ways of implementing such tactics from passive index strategies to highly active strategies to more alternative design kinds of strategies. Overall, the second part of this process enables us on an asset-by-asset class level to design the strategy within the asset class for either a risk-adjusted return advantage or for compatibility with our overall risk balance. The third part of the investment strategy is dynamic asset allocation, which starts with an annual assessment of longer-term prospects for the world’s asset classes. Every quarter we compile our strategic intermediate term outlook which combines our internal indicator work across various asset classes and from the bottom up security level with outside research. We develop recommendations across investment strategies from the synthesis of that bottom-up, top-down, quantitative, fundamental, internal, and external body of work. On a monthly basis, we formally update our indicator work and that helps to keep our outlook current in between the quarterly reviews. Furthermore, on a weekly basis, my team meets every Wednesday to review current developments in the market, everything from performance and volatility to liquidity. All that wealth of processed information feeds into an ongoing capital market view which could at any time result in a change in the portfolio deployment, our emphasis on risk and how much risk we are willing to take overall. Q:  How do you execute your asset allocation process? A : We start out by looking at the subcomponents that create investment returns in each of the asset classes. In equities, for example, earnings power of the companies is one component, changes in valuation is another. So, if we happen to be in a period when we expect earnings to accelerate, equity multiples are very low and we expect them to expand, and where there is an attractive investment yield, we will be likely to have a more bullish outlook for equities. Of course, the opposite will also be true. The next aspect of the asset allocation process is more of a cross-sectionally focused comparative process where we review the key dimensions in a diversified portfolio to develop indicators of proper alignment between pairs like stocks versus bonds, or international markets versus domestic markets, high yield versus Treasuries, emerging markets versus developed markets. As part of this, we are looking for either a pricing anomaly, where one side of that comparison is inexpensive compared to the other, or a fundamental opportunity where we identify that an advantage has accrued to one side versus the other. A significant part of our research effort over the years has been in identifying factors that have predictive influence on our comparative process and the proper way to measure and interpret asset classes. A good example of this approach is the comparison of high yield bonds to Treasury bonds. What we have found over the years is that high yield bonds tend to outperform when spreads are wide and adjusted for the credit quality of the index, or when the Treasury yield curve is steep and we have specific definitions for the steepness of the yield curve or when the economy is not in recession. Another example would be the comparison between small cap and large cap stocks. This is generally a slow moving dynamic of outperformance and underperformance that is linked to the economic cycle. For instance, when the U.S. economy is at the worst part of a recession, from there and until the peak of the next cycle smaller companies tend to deliver higher returns than larger companies. The opposite is also true when, at the peak of an economic expansion until the trough of the next recession; larger companies tend to outperform smaller companies. The next aspect of our asset allocation work is of more contextual nature. With the help of our investment clock approach, we diagnose current market conditions in terms of the business cycle and investor risk preferences to assess the asset classes that are either flattered or subdued by those prevailing conditions. We have a number of markets and economic statistics based indicators whose purpose is to classify the economic cycle into one of four classifications and to classify the risk taking cycle into either a risk seeking or risk-averse condition and various permutations of those. Q:  What are the analytical steps behind your research process? A : My team emphasizes empirical research. We like to make our investment decisions on the basis of tested, vetted and researched ideas as opposed to hunches and interpretations. For example, in designing portfolios of stocks, we spend a great deal of time looking for characteristics that are consistently rewarded in the stock market. Among the attributes associated with high performing stocks are attractive valuation, strong cash flow generation, sustainable financial management, and a strong balance sheet. After identifying a set of criteria that tend to be associated with outperformance, we incorporate them in our portfolio construction in combination with the research that we have done on building stock portfolios from the standpoint of low volatility and low beta construction techniques. Therefore, the ultimate composition of our equity portfolio is heavily influenced by that rigorous empirical research. In addition to that, we are very focused on understanding and trying to anticipate where the Achilles’ heel or vulnerabilities may be at any point in time. We have been focused for years on the evolving dynamic of a debt bubble. For instance, a couple of years ago we witnessed a very overleveraged private sector and the process of deleveraging was a dynamically unstable and potentially catastrophic one that was halted only by the public sector levering up and offsetting what was happening in the private sector. Since that has created a new set of vulnerabilities around public sector and sovereign debt, a good part of our contextual research today focuses on understanding the processes by which these vulnerabilities are either being handled or not. There is of course some relevant history to understanding that process, but it is also a form of research driven by current events that we pursue from a macro perspective. In summary, it is not just the economic view but also the degree to which pricing of securities and asset classes reflects that view that matters to our decisions. Q:  How do you build your portfolio? A : First we design our asset allocation. As we build the fund around a policy of risk parity design, we relax the no leverage constraint in order to achieve a better balance of risks. We can accomplish that by building a portfolio of risk balanced between the asset classes, which results in a fairly low volatility portfolio. Then, we can use leverage to move that volatility back up. Next, we consider the appropriate way to implement our exposure to each asset class. For example, we design our equity strategies to exploit an opportunity for better risk-adjusted returns. We build our equity portfolios from low volatility holdings which we think offer superior risk-adjusted returns over time. In other asset classes like government bonds, we simply aim to achieve asset class level returns mostly with the help of standard underpriced securities. In commodities, we gauge what the risk composition looks like within that asset class. For instance, we prefer not to be dominated by energy, so we might look to weight our commodities more evenly across energy, industrial metals, precious metals and soft commodities. An important part of our portfolio construction process is the integration of tail risk hedging strategies. One of the two kinds of tail risk hedges we utilize is simply to reflect that certain kinds of investments such as stocks have a history of generating unpleasant surprises more often. Consequently, in asset classes where we believe that we can expect tails, we want to use tail risk hedging to moderate the impact of those tailwinds when they occur. The second kind of a tail hedge is much more macro driven, taking into account those positions that we built around the specific vulnerabilities that we are paying attention to. Finally, we adjust the portfolio in accordance with our dynamic allocation views. The prospectus is fairly permissive with respect to allowable ranges for each asset class, so hypothetically we could own zero in any asset class or we could invest substantially more of the assets in a particular asset class than the policy would speak to. The binding constraint is not prospectus driven maximum and minimum exposure levels to various asset classes. The binding constraint for us is much more risk focused, as we target a certain volatility profile. In this way, allocating excessively in one asset class or another might move us too far away beyond our tolerances with respect to that volatility profile. Generally speaking, the overall volatility of our portfolio is similar to the volatility of a standard 60/40 balanced portfolio. Q:  How do you measure and mitigate risk in the portfolio? A : We have come to understand in our decades of managing money that big losses are more consequential in the wealth accumulation process than big gains are. We really focus on avoiding any unnecessary drawdown and big losses through a number of methods that we employ to deliver that kind of risk management. As part of our overall diversification design we configure the risks very differently so that we are not dominated by equities or some other risky asset. What is more, we are focused on keeping the portfolio intact even under adverse conditions. We feel that from an operational point of view that is a more powerful risk definition than standard deviation of return or some other statistical measure.