QS Investors Diversification Based Investing Whitepaper - FTSE

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Step 3 | Weight The objective is to engineer a diversified exposure to the key drivers of risk and return. By design each cluster has a low correlation to other clusters, and from an intuitive standpoint describes a risk theme in the market such as global commodities, financial services/cyclical stocks or Japanese non-cyclicals. Market capitalization indexes may have high weights to a particular risk theme such as cyclical stocks, and low weights to other risk themes such as Japanese noncyclicals. In contrast, DBI seeks a more diversified exposure to risk themes in the market by equal weighting all clusters. In effect, DBI avoids forecasting which risk theme will do better than others. This diversification approach forms the Figure 8: Example of three “Clusters” within FTSE DBI Developed Index Portfolio Weight As of September 30th, 2010. Source: QS Investors LLC. For illustration purposes only FTSE DBI Page 10 11% Cluster 1 0.36% Australia Industrials 0.36% Australia Financial Services 0.36% Austria Financial Services 0.36% Belgium Financial Services 0.36% Canada Industrials 0.36% Canada Financial Services 0.36% Switzerland Financial Services 0.36% Denmark Financial Services 0.36% Germany Consumer Goods 0.36% Germany Technology 0.36% Spain Financial Services 0.36% Finland Basic Materials 0.36% Finland Financial Services 0.36% Finland Technology 0.36% France Financial Services 0.36% France Technology 0.36% Great Britain Financial Services 0.36% Greece Financial Services 0.36% Ireland Industrials 0.36% Italy Consumer Goods 0.36% Italy Financial Services 0.36% Netherlands Industrials 0.36% Netherlands Financial Services 0.36% Sweden Consumer Goods 0.36% Sweden Financial Services 0.36% United States Basic Materials 0.36% United States Industrials 0.36% United States Consumer Goods 0.36% United States Consumer Services 0.36% United States Financial Services 0.36% United States Technology Portfolio Weight heart of DBI’s portfolio construction process. As risk units within a cluster are highly correlated, there is no reason to overweight one compared to the other. Thus each risk unit is equally weighted in each cluster. Figure 8 illustrates three cluster examples as of September 30th, 2010. At this time, the DBI process for the FTSE DBI Developed Index created 9 clusters so each cluster had a 11.1% weight (i.e. 100% ÷ 9). Risk units in clusters that contain many risk units have relatively smaller weights in the portfolio. By construction, risk units in larger clusters will be highly correlated with more of the other risk units; therefore, they are not good portfolio diversifiers and should have a lower weight. 11% Cluster 2 2.78% Japan HealthCare 2.78% Japan Consumer Services 2.78% Japan Telecommunications 2.78% Japan Utilities Portfolio Weight 11% Cluster 3 0.85% Australia Oil and Gas 0.85% Australia Basic Materials 0.85% Canada Oil and Gas 0.85% Canada Basic Materials 0.85% France Oil and Gas 0.85% France Basic Materials 0.85% Great Britain Oil and Gas 0.85% Great Britain Basic Materials 0.85% Italy Oil and Gas 0.85% Japan Oil and Gas 0.85% Norway Oil and Gas 0.85% Norway Basic Materials 0.85% United States Oil and Gas
To further illustrate how good and bad diversifiers are weighted in the portfolio, figure 9 shows how Netherlands Financial Services (1 of 31 risk units in Cluster 1) and Japanese Utilities (1 of 4 risk units in Cluster 2) are correlated to all other risk units. Netherlands Financial Services shows relatively high correlations to almost all other risk units and is therefore not a good diversifier. Intuitively this means that there are many risk units that have a Correlation 100% 80% 60% 40% 20% 0% -20% -40% Step 4 | Implementation The objective of this step is to capture structural changes between countries and industries, while controlling turnover to keep transaction and market impact costs low. The clustering process occurs annually when the largest part of the relevant FTSE benchmark reconstitutes. For example, the FTSE DBI Developed Index reclustering is completed in December to coincide with the constituent review FTSE DBI Page 11 Risk Units common risk exposure (cyclical/financial services). As a consequence, it is grouped in a Cluster with many risk units and gets a small total portfolio weight (0.36%). In contrast, Japanese Utilities is highly correlated to only a few other risk units and is negatively correlated with over half of the other risk units. Because of this, it is a good diversifier; it is therefore grouped in a cluster with fewer risk units and is allocated a higher weight (2.78%) as a consequence. Figure 9: Overweighting good diversifiers; correlation pair example – two risk units to every other risk unit Japan Utilities (1 of 4 Risk Units in Cluster) Netherlands Financial Services (1 of 31 Risk Units in Cluster) 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100 103 106 109 112 115 118 121 As of September 30th, 2010. Source: QS Investors LLC. For illustration purposes only High Correlation Bad Diversifiers Low Correlation Good Diversifiers (reconstitution) that occurs in that index for North America. As constituent names will change in December, DBI changes clusters / risk unit weights / stock specific weights to coincide with that turnover. Immediately after that, market drift occurs. To maintain diversification, the DBI Indexes are rebalanced back to the original diversification weights once a quarter. This process is illustrated below in Figure 10. Figure 10: Implementation – Example of Clustering and Rebalancing timeline for FTSE DBI Developed Index Cluster Rebalance Rebalance Rebalance Cluster December March June September December
Page 1: W H I T E P A P E R FTSE DBI (Diver
Page 4 and 5: 1 | Rationale and philosophy DBI is
Page 6 and 7: The increased weight reflected a st
Page 8 and 9: 2 | The DBI investment process DBI
Page 12 and 13: 3 | Performance analysis In this se
Page 14 and 15: 4 | Risk exposures Active risk expo

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