QS Investors Diversification Based Investing Whitepaper - FTSE

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2 | The DBI investment process DBI takes into account the observed characteristics of markets and indices described earlier, and uses them to create a more diversified index. The strategy’s investment process has four steps: 1 | Assign all stocks to risk units defined by the key drivers of risk: country and industry 2 | Identify highly correlated risk units, and group them in a single “cluster” 3 | Weight the clusters and the risk units in them equally. The objective of equal weighting is to achieve a high level of diversification 4 | Rebalance the index to capture changes in market dynamics These four steps are described in more detail. FTSE DBI Page 8 Step 1 | Partition Figure 6: All Risk Units and example of two within the FTSE DBI Developed Index Australia Austria Belgium Canada Denmark Finland France Germany Greece Hong Kong Ireland Italy Japan Netherlands Norway Portugal Singapore Spain Sweden Switzerland United Kingdom United States Basic Materials Consumer Goods Consumer Services Financial Services Risk Unit 1 The objective of this step is to group stocks with common drivers of return. As the country that a company resides in and the industry they compete in are the key drivers of risk in a diversified portfolio, we use FTSE’s categorization of stocks to partition each stock in to a single country/industry “risk unit”, for example Netherlands Financial Services or Japanese Utilities. Every stock in the relevant FTSE index, e.g. FTSE Developed Markets, is assigned to one of these risk units. Figure 6 shows all Risk Units and highlights these two examples. Health Care Industrials Oil & Gas Technology Telecommunications Utilities Risk Unit 2
Step 2 | Cluster In this step, we cluster the risk units to identify diversification potential. Once a year, we use statistical analysis based on correlations over the last five years to identify risk units that are highly correlated to each other. We group highly correlated risk units in to clusters so as to maximize the correlation of risk units within clusters and minimize the correlations between clusters. Each cluster can be thought of as a risk theme in the market. If investors have viewed risk units as being highly correlated or driven by a common risk factor, then the correlations will be high and these risk units will be grouped into the same cluster. Two examples of clusters in 2010 are illustrated in Figure 7: Cluster 1, global financial services/cyclical stocks; and Cluster 2, Japanese noncyclical stocks. Figure 7: Example of two clusters in FTSE DBI Developed Index Australia Austria Belgium Canada Denmark Finland France Germany Greece Hong Kong Ireland Italy Japan Netherlands Norway Portugal Singapore Spain Sweden Switzerland United Kingdom United States Source: QS Investors LLC For illustrative purposes only FTSE DBI Page 9 Basic Materials Consumer Goods Consumer Services Financial Services Cluster 1 Financials Svcs/ Cyclical Some clusters are based primarily around sectors, while others are determined more by geography. In the above example, Financial Services are more globally integrated and reside in cluster 1 while there are only Japanese risk units in cluster two. In total DBI targets 10 clusters. At times there is not enough difference between risk units to form 10 clusters so that 9 clusters are the optimal number. For example, if the 10th cluster only has one or two risk units in it, it means that there is not enough difference between risk units in the 10th cluster and another cluster. If this occurs, we rerun the process targeting 9 clusters and the index will only have 9 clusters for that year. Health Care Industrials Oil & Gas Technology Telecommunications Utilities Cluster 2 Japan Non Cyclical
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