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Active Portfolio Management: Country vs. Sector Characteristics

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Active Portfolio Management: Country vs. Sector Characteristics

Executive Summary
This project sets out to invest between 7bn and 9bn Euros for a large pension fund in European equities, chosen from the MSCI Europe Index, which also serves as the benchmark to measure performance against. Two portfolios need to be created, one to reflect asset allocation focussed on countries and the other on sectors, with the number of assets in each portfolio being no more than 150. Both portfolios must be actively managed, having at least an active risk of 3% when compared to the benchmark. To achieve this, I followed a three step top-down approach for our investment decision process. Firstly, I started with an analysis of the macroeconomic environment in Europe, followed by forming opinions on the relative strengths and weaknesses of the constituent countries and sectors, using the macro-analysis to determine which are most likely to perform well, given the long-run trends identified. Finally, I invested in all mid-cap companies within the selected countries and sectors, based on our judgement that middle sized firms are poised to prosper the most in this difficult economic environment, which I predict to remain tough for the foreseeable future. After finalising the initial portfolios in this way, I used BarraOne to optimise them. Following optimisation, I compared the risk profile of each portfolio to the benchmark. Our findings show that an actively managed portfolio, especially one constrained to 150 assets, will necessarily be less diversified than the benchmark. For the country portfolio, the lack of diversification materialised in a high level of currency risk, which I purposely limited using a constraint during the optimisation process. This was to be expected when considering that the exclusion of some countries from the portfolio would also change the mixture of currency exposure when compared to the benchmark, increasing currency risk. The sector portfolio suffered more from selection risk, because limiting investment to just a few sectors reduces the benefits of diversification across many sectors, which are each affected differently by the various stages of the economic cycles. In terms of active risk management, by looking at active exposure and the marginal contribution to risk of different factors, I identified a clear link between the two. It is then apparent that any adjustment that makes the portfolio more similar to the benchmark, by reducing a specific active exposure, is also likely to reduce active risk, although this will not strictly be the case for all factors. In conclusion, an actively managed portfolio is bound to be less diversified than a broad index. This should be hardly surprising, as active management means taking extra risks, which stem from bets that distinguish the active portfolio from its benchmark, usually resulting in an asset allocation that is less diversified. As is often said, there is no free lunch in finance.

For this project I assume the investor, a pension fund, to be mainly concerned with investment risk thus no return objective will be specified. Two portfolios, one based on country and one based on sector allocations, are to be constructed using an active management approach, meaning that active risk must exceed 3% when compared to the MSCI Europe Index, acting as the benchmark. Following the strategic asset allocation already decided on by the investor, all assets must be chosen from the benchmark (i.e. European equities only) and the total number of assets may not exceed 150. The investor’s risk tolerance is assumed to be 0.075. Since the investor is a pension fund, the investment horizon is deemed to be long term. Total funds available for investment range from 7bn to 9bn Euros. Any tax, ethical and other legal requirements have been ignored, as will be any transaction costs.

Benchmark Analysis: MSCI Europe index
The Benchmark Market Index used in this analysis is the Morgan Stanley Europe Index (MSCI Europe Index) on the 5th of September, 2012. This Market Index consists of 447 stocks selected from European Countries. The total Market Value of this Benchmark Market Index is 79,346,187,415.69 euros.
The graph below portrays the Top 10 countries in terms of their weights in the benchmark. Most of the stocks of the benchmark are from the United Kingdom (35.44%), France (13.94%), Switzerland (13.30%) and Germany (13.17%), among which the United Kingdom contributes nearly one third. These countries fall in the top economies within Europe.

Table 1. Country weights in Benchmark MSCI Europe
The three sectors with highest weight in the Market Index are Financials (19.34%), Consumer Staples (14.85%) and Health Care (12.36%). The total risk of the Benchmark Index is 19.90% in terms of annualised standard deviation of return. The total risk is composed of 99.76% of Local Market risk, 2.69% of Currency risk and -2.45% of Currency/Market Interaction risk. The total risk of 19.90% is influenced by a low correlation of 9.23% between industry and style. The benchmark has a low selection risk of 0.32%, because the portfolio is made up of 447 assets making it well-diversified.

Portfolio Analysis: Country allocations
The economic outlook for Europe remains gloomy as worries about the lingering debt crisis and serious doubts about the continent’s future economic growth potential persist. The European market experienced its major setback in 2008 when most countries fell into debt crisis, which they have not yet fully recovered from, with Greece been the hardest hit. Attempts are being made by governments and central banks to enable the EU to emerge out of the debt crisis.
The country portfolio is made up of seven countries; Belgium, Switzerland, Germany, France, Italy, Norway and Sweden. Table 1 shows their respective weights against the benchmark used, which is MSCI Europe.

Table 2. Country weights in initial Country portfolio
Belgium’s GDP for 2011 was US$ 511.53 billion with an anticipated growth rate of 0.37% in 2012. Belgium’s economy is greatly influenced by foreign trade and remains well positioned to continue its growth. Its geographical position as well as its infrastructure gives it the promise to remain as the entry point for goods and services in Euro zone. Therefore, I give a weight of 10% to Belgium, whose active weight is 8.21%.
The GDP growth of Switzerland has been declining but continues to remain above zero, with a prediction of 0.85% this year and 1.35% in the next year. The inflation has been consistently below 0.7 (IMF, 2012), partly due to the fact that Switzerland has the world’s lowest interest rate. Swiss authorities have taken powerful measures to stimulate the economy. The weight of Switzerland in the initial portfolio is 7.5%, under-weight than that in benchmark.
Germany currently reported a surplus balance of trade of 16.9 EUR Billion in August 2012. This has been a trend over the years as export is its highest source of income. It is expected to continue to be a leading economy with growth in its services industry, especially its technology and finance sectors. Therefore, Germany has the highest weight (25%), with an active weight of 11.83%.
The GDP in France fell dramatically in 2009, after which it became stable. However, the GDP in 2012 Q2 fell by -0.1% (INSEE, 2012), which was mainly because of the total domestic demand shrink. Exports always fluctuate heavily than imports, except that predicted in 2013, indicating a future weakness of France’s future competitive power. In the country portfolio, France is under-weight the benchmark with a weight of 10%.
Because of its famed luxury goods, Italy has a very strong brand for the finer things in life. It is thus likely to benefit from the rise of emerging economies. Its north is also home to a number of healthy financial and industrial giants, making for suitable investment opportunities. Therefore, Italy was given a high weight of 17.5% in the initial portfolio with an active weight of 14.07%.
The GDP in Norway is recovering more quickly than other European countries, estimated to grow by 3.06% this year (IMF, 2012). The unemployment rate in August was lower compared with other countries. Low interest rate and high demand in the petroleum industry are the two main reasons why Norwegian economy performed better than other countries (Statistics Norway, 2012). Norway has a high portfolio weight (15%), with an active weight of 13.53%.
According to the IMF, Sweden’s public finances are one of the strongest in Europe. It had a fast recovery from the 2008 crisis due to its export markets and domestic policy (IMF, 2012). As OECD signals, its macro-economy has grown significantly faster than the OECD area as a whole (OECD, 2012). All the previous industrial and economy features lead us to believe that Sweden is a safe country to invest in. Hence, it is given the same weight as Norway (15%), with an active weight of 10.22%.
Portfolio Analysis: Sector allocations
As shown in the following graph, seven sectors have been selected in the Sector portfolio with differing weights from that in the benchmark.

Table 3. Sector weights in initial Sector portfolio

Information Technology was selected because is experiencing rapidly industry growth, with a strong demand from both private and business sectors. Although in a recession, there is an increased spending on servers, storage and networks. IT technology is a necessity in today’s business environment; so, I allocate 21% of the fund to IT sector, much more than 2.88% present in the Benchmark.
Because of a stabilising and ageing population, demand of the utilities sector is unlikely to change much. This predictable environment promises a less risky investment opportunity during a difficult economic climate. The sector’s high dividend yield makes it desirable too. Future growth in this area looks promising if the industry reacts quickly enough to become major players in these nascent markets. Therefore, I invest as much as 21% of the fund into utility sector, with an active weight of 16.85%.
The Telecommunications industry is another sector chosen to invest in. Although fixed-line services are declining worldwide, mobile services demand is continually increasing. It is expected that the number of mobile phone subscribers will rise to 6.4 billion by 2015 (QFinance, 2012). These stocks can be considered safe bets because of high capital investments and high cash flow generation capacity. In light of such characteristics, I decided to allocate 21% of the fund to this sector, as opposed to 5.98% in benchmark.
Manufacturing is a major contributor to the European GDP. Industries sector seems to be recovering although its output is still 17% of its peak level. In 2011, industrials sector in Europe produced an output worth $4377 billion leading the world’s Industrials sector. Thus, a proportion of 16% of funds is invested in this sector.
With respect to Energy sector, from the macro analysis of Europe, it is inferred that the business will not enter the recovery cycle soon; because energy demand will slow down during these years. The supply structure of energy is experiencing an evolution, which means that renewable energy is becoming more and more important; thus, only those companies that firstly grasp the technology will excel. Therefore, I will invest relatively low weight (7%) during this slowdown period, with an under-weight of 4.26% compared with the benchmark.
Nowadays, costs of healthcare are increasing due to an ageing population and the demand of better treatments, not completely met by public healthcare. On the other hand, according to World Bank, public expenditure on healthcare will rise to 14% of GDP in the European Union, in 2030 (The Economist, 2011). Healthcare companies are considered defensive stocks to invest in, because it is difficult for people to cut their spending on it (QFinance, 2012). However, because I are managing the portfolio on an active basis, I set the weight of 7%, with an under-weight of 5.36%.
Traditionally, consumer staples, is viewed as one of the least affected by the economic climate and thus a fitting choice for a highly risk averse investor. However, consumers in developing countries will start demanding basics such as household cleaners as they become richer. Since consumer staples can be easily shipped and many of the firms within this sector are large multinationals, their growth in revenues and profits will increasingly depend on the fortune of developing countries. Due to the similar reasons to that of healthcare, I set the weight of consumer staples as 7%, with an under-weight of 7.85%.

Company Analysis
Once the decision process has been made for countries and sectors to invest in, the individual companies’ selection has been made focusing on middle-cap companies. Middle-cap companies tend to be less risky than small-caps and provide higher growth potential than large-caps companies.
Middle-cap companies are those with market capitalization between 2 and 10 billion. Following this procedure, I left out big-cap companies to achieve an actively managed portfolio. Apart from this reason, big-cap companies are presumed to face difficulties in the future, due to heavier tax burden and social opinion towards multinationals. In the other hand, small-cap companies will be the weakest competitors, and probably those first to fail. Mid-cap companies are more likely to survive economic difficulties without facing political and social backlash than big-cap companies.
Weights for countries and sectors were selected taking into account the corresponding weights in the Benchmark. Following this comparison, it had been tried to maintain similar concentrations than those in the Benchmark; but also, changing the weights for the biggest ones.
For the optimization process of the Country portfolio, because that avoiding currency risk became difficult, a constraint of a maximum of 15% in Currency risk was set; and the “Sell none” constraint was also selected. The Sector portfolio was optimised using the BarraOne default profile.

Risk Profile: Country Portfolio vs. Benchmark
The largest active weight is in Subsea 7, a seabed-to-surface engineering company, representing a bet on the future prospects for exploration of deep sea oil reserves. The weights of the following nine stocks gradually decline from 2.42% to 1.58%, including Norwegian, Italian, Belgian, German and Swiss stocks.

Table 4. Top 10 Active weights in Country Portfolio
For the bottom ten holdings, active weights range from 0.06% to -0.09%, with Assa Abloy, a Swedish lock maker having the lowest weight. The remaining stocks are also either Swedish, with a few French and one Belgian.

Table 5. Bottom 10 Active weights in Country Portfolio

In terms of total risk, the portfolio risk is 4.07% higher than the benchmark, with an active risk of 7.01%. Around 85% of active risk can be attributed to Local Market Risk which consists of Common Factor Risk and Selection Risk. The latter figure means that around 12% of active risk is caused by the selection of assets, a result of the portfolio containing fewer assets and being less diversified than the benchmark. For the same reason, the portfolio risk from Factor Interaction is somewhat greater than for the benchmark, representing 14% of active risk. The percentage of active risk due to Style is more than a fifth, which is desirable in an actively managed portfolio. The remainder (37%) is caused by Industry. This is in line with expectations, since most of the portfolio risk of the benchmark also comes from this common factor. That 16% of active risk is due to Currency Risk can again be explained by reduced diversification as well as by the exclusion of UK companies. A slightly negative Currency/Market Interaction means that the effect from the large negative active weight on the UK is somewhat counteracted by the choice of the other countries.

Table 6. Risk decomposition graph for Country portfolio
The biggest contributor to active Local Market Risk is the UK, followed by Italy, Germany, Norway and Belgium. The ranking fairly accurately reflects the absolute value of active weights in the countries of the initial portfolio, bar Sweden whose weight was reduced significantly by the optimisation. For all countries the major source of common factor risk is industry, although style is a relatively important aspect for and France. Noteworthy is the -129.87% for Market Interaction, indicating that the choice of countries has a high diversifying effect, reducing local market risk and in particular counteracting the active risk from not investing in the UK. The benchmark has a Market Interaction of 81.25%.
Looking at the three largest factor exposures of a few selected countries, Italy’s largest active exposures come from Machinery (2.42%), Utilities (2.05%) and Autos & Components (1.85%). For Germany, active exposures are largest to Other Materials (2.55%), Machinery (1.75%) and Pharmaceuticals (1.57%), and Norway’s exposure is mostly to Energy Equipment and Services (6.55%), Metals and Mining (1.53%) and Other Capital Goods (1.52%). From these figures it is apparent that the portfolio focuses on industries with tangible products, goods that are to a large extent manufactured by mid-cap companies, in line with the investment objectives.
The most important styles are volatility, size, value and liquidity. All these factors are associated with the characteristics of mid-cap companies, which are more likely to have a volatile share price, affected by their size and value whilst being more thinly traded than large-cap stocks. Therefore the exposures and risks due to these styles are the predictable result of investing in mid-cap companies only.
In terms of Currency, unsurprisingly the portfolio is heavily underweight in British Pounds, overweight by ca. 9% in the Norwegian Krone and somewhat in the Swiss Franc (3%), with the Pound clearly causing the most active risk (2.91%).

Table 7. Currency risk decomposition for Country portfolio
The factors grouped by sectors contributing most to total risk are Energy, Materials and Consumer Discretionary, with Metals and Mining being represented heavily. This is also reflected in MCAR, with Materials, Industrials and Information Technology contributing the most, and again Metals and Mining having a large impact.

Active Risk management
By reducing the weight in the factors with the highest positive MCAR as identified above, especially Materials, active risk could be reduced. The proceeds could then be invested in British stocks, as this would reduce the currency risk to the Pound, with a MCAR of currently -0.03%. In terms of style, investing more in Momentum and Size would reduce active risk by around 0.01% per country and style. All other MCAR values are virtually zero or positive, meaning that active risk could only be reduced by shifting out of highly positive MCAR factors and shifting into less positive MCAR factors. This analysis is vice versa true if active risk was meant to be increased instead.

Risk Profile: Sector Portfolio vs. Benchmark
The top 10 holdings of the portfolio are in the Industrials, Consumer Staples, Health Care, Telecommunication Services and Information Technology sectors. According to the economic analysis, both industrial and consumer staples are good sectors to invest in a recession time; also, these companies are multinational so they can make profits in outside the European zone.

Table 8. Top 10 weights for Sector portfolio

The bottom 10 percentage holdings are shown in the next graph.

Table 9. Bottom 10 weights for Sector portfolio
The total active weight of the Sector portfolio is 90.59%. This number indicates that the portfolio is 90.59% over-weighted compared to the benchmark.
In terms of active weight (the weight of an asset in the sector portfolio minus the weight of the asset in the benchmark MSCI Europe Index), the more over-weighted sectors are Industrials, Consumer Staples and Health Care. Compared to the rest of the sectors present in this portfolio, there is a huge bet on Industrials sector, coinciding to the last stage of a recession period.

Table 10. Active weights by sectors The Total Risk of the Sector Portfolio is 19.48, meaning that the portfolio has a two-thirds probability of falling within 19.48% of its expected return over the next year. The Active Total Risk of the sector portfolio is 3.74, meaning that it has a two-thirds probability of falling within 3.74% of the benchmark. The Benchmark Total Risk is 19.90, so the Sector Portfolio is a less risky portfolio.
According to the Barra report, 99.99% of the Sector portfolio active risk arises from local market risk. Of the 99.99% of local market risk, 68.83% can be explained by Common factor risk and 31.16% by Selection Risk. In respect to Common factor risk, it can be divided by 33.83% in Industry risk, 43.88% in Style risk and -8.87% from Factor Interaction.

Table 11. Risk decomposition graph for Sector portfolio
The big percentage of Common factor risk can be due because 52.88% of the Active Weight of this portfolio is allocated in just two sectors: Industrials and Consumer Staples; within the Common factor risk, Style risk has the biggest percentage. The countries allocation is more diversified and the two countries with major Active Weight represent 39.31% of the portfolio, which explain the lower level of Selection Risk in the portfolio.
The previous graph shows that the portfolio is well diversified, and in fact, factor and market interaction contribute to decrease the total active risk. Style risk and industry risk are contributing to the active risk, mainly due because this portfolio has been constructed for an determined group of industries and is not replicating the benchmark itself.
Biggest contributors to Local Market Risk are United Kingdom and Germany, explaining 75.34% of the Active Local Market Risk which is 3.74. United Kingdom’s risk comes from Common factor risk (2.73) with Industry as the greater contributor; Germany’s risk comes also from Common factor risk with also Industry as the greater contributor.
In the case of United Kingdom, the active exposure information can be seen in the next graph. Food Staples and Retailing, and Energy Equipment and Services are the most overweight British industries, but there is underweight in other industries as well.

Table 12. Factor exposures for Great Britain in Sector portfolio
For Germany, active exposures are smaller than British ones; and in this case, the portfolio has more underweight industries in this country; in fact, there are only 13 German stocks in the portfolio and 11 of them have active weights of less than 1%. The more important active exposures are in German Machinery, Pharmaceuticals and Food and Staples Retailing Industries.

Table 13. Factor exposures for Germany in Sector portfolio
Currency risk of the sector portfolio is contributing to 3.88% of the Active Risk, which is bigger than that of the Benchmark, 2.69%. The biggest exposures in the Sector portfolio are to Euro and British Pound currencies; for the Euro, compared with the Benchmark, is overweight by 9.77% and underweight by 7.79% for the British Pound. The portfolio is also underweight for Swiss Franc, Danish Krone and Norwegian Krone; in terms of currency, this appears to be a diversified portfolio.
In terms of Marginal Contribution to Total Risk of the portfolio, the three biggest contributors are Austrian Metals, Finland Autos and Components and French Metals; all these three factors are absent in the portfolio, but an increase in these stocks of 1% would increase the risk of the portfolio in almost 24% for each factor. This result shows that the portfolio has efficiently excluded risky factors and, in general, there are small exposures for the factors contributing more to Total Risk.
In terms of Marginal Contribution to Active Risk, there are no factors that might increase the total Active Risk. All the factors have zero or negative values in the Marginal Contribution to Active Risk, meaning that an increase in their exposures will have no effect or even decrease the Active Risk of the portfolio.

Active Risk management
To decrease Active Risk in the Sector portfolio, the weight of Great Britain Banks could be increased by 1% and the active risk of the portfolio would be decreased by 0.08%, this is the factor that would have a stronger marginal effect in decreasing the active risk. Also, an increase of 1% in the weight of Banking Industry of Germany, Spain, Italy or France would decrease the active risk by 0.06% each, holding all else constant. This is not surprising given that all the Banking Industry is completely excluded from this sector portfolio, so adding some exposures to banks would diversify it.

Changes in Net Asset Value for Country and Sector Portfolios The percentage change in NAV from 5th to 26th September 2012 was 2.11% for the benchmark compared to 3.45% for the country portfolio and 3.35% for the sector portfolio.

Conclusion In this project I created two actively managed portfolios and analysed their risk profiles, with the MSCI Europe Index as the benchmark. Yet the selection procedure that gave rise to active risk also lessened the benefits of diversification. For the country portfolio this issue was most pronounced for currency risk, as over- or underweighting some countries created currency exposures which were less diversified. Especially because the benchmark has a large exposure to the British Pound, if the investor does not want exposure to the UK, the portfolio will exhibit a high currency risk when compared to the benchmark. On the other hand, this might be a desired outcome, or the exposure can be hedged in the foreign exchange markets. Similarly, for the sector portfolio the problem was most visible in selection risk, which by definition can be diversified away, since leaving out entire industries means that the assets remaining in the portfolio are likelier to be more closely correlated. Diversification also proved to be a difficulty during the optimisation step. Apart from the limitation to just 150 assets, much tweaking to country and sector weights was required to find two portfolios that maintained a sufficiently high active risk after optimisation, since the software attempted to achieve maximum diversification benefits, often reducing active risk below 3% as the optimised portfolio was made more similar to the benchmark. Consequently, reducing (increasing) active risk requires adjusting assets weights in a manner that make them more (less) similar to the benchmark weights, yet because the benchmark is highly diversified, an actively managed portfolio will usually have a lower level of diversification.

INSEE, 2012. Goods and Services: Supply and uses chain-linked volumes. [accessed 18 December 2012]
INSEE, 2012. The unemployment rate. [accessed 18 December 2012]
IMF, 2012. Norway: Gross domestic product, constant prices. [accessed 18 December 2012]
Statistics Norway, 2012. Economic trends for Norway and abroad. [accessed 18 December 2012].
OECD, 2012. OECD Science, Technology and Industry Outlook 2012
QFinance, 2012. Healthcare and pharmaceuticals. [Online] Available at: [Accessed: 15 December 2012]
The Economist, 2011. The future of healthcare in Europe. The Economist Intelligence Unit Limited 2011.

Appendix 1. Benchmark Risk Profile

Appendix 2. Country Portfolio Data A.2.1 Country Weights

A.2.2 Country Portfolio Risk Profile

Appendix 3. Sector Portfolio Data A.3.1 Sector Weights

A.3.2 Sector Portfolio Risk Profile

Appendix 4. Changes in Net Asset Values

[ 1 ]. The countries included Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom
[ 2 ]. Figures from Trading Economics

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Yale University Investment Model Swensen had every reason to feel content, despite his recent injury. The endowment had just completed another spectacular year, having grown to $18 billion (up from $1 billion when he had taken over the office). Yale had developed a rather different approach to endowment management, including substantial investments in less efficient equity markets such as private equity (venture capital and buyouts), real assets (real estate, timber, oil and gas), and “absolute-return” investing. This approach had generated successful, indeed enviable, returns. Swensen and his staff were proud of the record that they had compiled and believed that Yale should probably focus even more of its efforts and assets in these less efficient markets. But his thoughts turned to the larger challenges associated with the management of the university’s endowment. The very success of their strategy had generated new questions. How far did they think Yale should or could go in this direction? How should they respond to the growing popularity of the approach they had chosen? Given the turbulent times that private equity funds were facing, should this asset class continue to play an integral role in Yale’s portfolio? Background1 Ten Connecticut clergymen established Yale in 1701. Over its first century, the college relied on the generosity of the Connecticut General Assembly, which provided more than half of its funding. The creation of a formal endowment for Yale was triggered by the 1818......

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Ratio Analysis China-centric US equities have lagged (Exhibit 22) and are cheap (Exhibit 24) vs. US-centric equities. Our Global Economics Team forecasts 1H 2013 China GDP growth will be improving, something not assumed in either the US or Europe. We believe a combination of dividend and dividend growth will outperform in 2013. Fears about dividend tax rates persist, but the cohort looks compelling given low payout ratios, attractive yields vs. bonds, and record cash balances that could benefit from tax reform or repatriation in a grand bargain. Mega caps remain attractively valued (Exhibit 37) and generally are higher quality with better estimate achievability than the broader market. We are not making a strong growth / value bet given that revenue results have been muted of late (Exhibit 39). Phillip Neuhart Yaye Aida Ba We made a number of sector changes for this 2013 outlook. Our new sector recommendations are shown in Exhibit 43 with details beginning on pg. 18. 1) We have upgraded industrials from market-weight to overweight and downgraded technology from overweight to market-weight. We have downgraded financials from market-weight to underweight. We have downgraded staples from market-weight to underweight, remaining overweight health care. We have upgraded energy from underweight to market-weight. 2) 3) 4) Our portfolio changes are generally skewed toward the three themes we identify in the second......

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