Lord Abbett's Calibrated Large Cap Value strategy has a distinctive approach to seeking higher relative returns without taking on higher relative risk. This is accomplished through a process that is extremely discriminating in the types of active risk that are taken in pursuit of delivering consistently superior performance. The strategy's portfolio managers focus their active risk on stock-specific risk, while minimizing active risk from sector, style, and other macro-factor exposures. Rick Ruvkun, Partner & Director of Calibrated Equity Management, and Walter Prahl, Partner & Director of Quantitative Research, co-manage the strategy.

Q. What is the Calibrated Large Cap Value investment approach?
A. The investment approach for Calibrated Large Cap Value is similar to that used in our Calibrated Suite of equity strategies. Our Calibrated equity strategies offer reliably style-consistent, sector-neutral portfolios that seek to outperform their benchmarks by focusing on stock selection. Each Calibrated equity strategy minimizes relative macro risks, compared with its benchmark, while maximizing the benefits of our extensive fundamental and quantitative research.

Q. Why do you believe this approach will be successful?
A. Our research suggests that it is extremely challenging for a portfolio to have meaningful relative sector bets and still generate consistent outperformance. For example, the average large cap value mutual fund will often have 4–5% over- or underweighting of some sectors versus the Russell 1000 Value Index,¹ according to the portfolio analytics firm Axioma, Inc. Frequently, large sector bets can be a major driver of extended periods of outperformance and underperformance for those funds. With the Calibrated equity strategy, we believe that taking a sector-neutral approach provides a platform for us to deliver more consistent outperformance versus the benchmark.

Q. Is the Calibrated approach just about sector neutrality?
A. While the sector-neutral aspect is perhaps the most visible feature of our active risk management, the overarching concept is to reduce the sources of common factor risk within the portfolio, regardless of whether those factors are sector, industry, capitalization, or style. It is our goal to have very little relative exposure to those common factors, thus providing a platform to focus our active risk on stock selection.

Q. How do you generate alpha with this approach?
A. We seek to generate alpha through overweighting the most undervalued stocks and underweighting the most expensive stocks within each sector and industry. We believe that predicting macroeconomic trends in order to over- and underweight sectors and industries is more difficult than uncovering undervalued stocks. Our research and performance to date have shown that even with a sector-neutral portfolio, there is ample opportunity for outperformance through skillful stock selection.

Q. How do you identify undervalued stocks?
A. Our analysts seek to uncover undervalued stocks with trenchant insights into company prospects. This is complemented by the use of our proprietary valuation model to identify businesses whose intrinsic value could be much higher than the current stock price.

Q. How do you determine intrinsic value?
A. To estimate intrinsic value, we essentially need to answer two questions: what's a company going to earn in the future, and what are those earnings worth? The process begins with Lord Abbett research analysts' fundamental forecasts for companies within their universe. These forecasts include near-term earnings, intermediate-term growth rates, and long-term earnings potential. The Calibrated portfolio team then uses a proprietary model to determine each company's appropriate discount rate based on a combination of company and security characteristics, including historical volatility and the most recent book value. Those inputs go into Lord Abbett's valuation system to calculate an estimated intrinsic value for each stock.

Q. How is the Calibrated Large Cap Value portfolio constructed?
A. The portfolio is constructed based on two competing objectives: overweighting the stocks with the greatest undervaluation, while simultaneously ensuring that the portfolio does not deviate too much from the benchmark in sector, industry, capitalization, style, and other common risk factors. Ultimately, the final portfolio is the one that we believe has the highest relative expected return given the portfolio constraints.

Q. What are the portfolio's weighting limitations?
A. Our portfolio constraints are based on active weights versus the Russell 1000 Value Index. For example, plus or minus 0.5% for each sector (for example, financials), plus or minus 1% for each industry group (for example, banks or insurance), and plus or minus 2% for each stock. We also make sure we’re diversified across relative, core, or deep value stocks.

Q. How do you incorporate risk management?
A. Risk management is a key component of Lord Abbett's approach to investment management. In the Calibrated Large Cap Value strategy, we are acutely aware of the relative risks that we take compared with the Russell 1000 Value Index. Calibrated Large Cap Value's risk management approach is to focus on active risk from stock selection, seeking to minimize all other sources of relative risk. In order to accomplish this objective we implement two procedures: 1) set specific, allowable, active-risk ranges for sector, industry group, and individual holdings and 2) manage portfolio aggregate risk exposures for a selected group of risk factors (for example, momentum, volatility) to be similar to the Russell 1000 Value Index.

Q. Why is this approach beneficial to portfolio allocators?
A. The Calibrated Large Cap Value strategy, which is reliably style consistent and sector-neutral, provides two benefits to advisors, analysts, and consultants that build a portfolio on behalf of their clients. First, portfolios that have style drift can reduce the expected diversification benefits for the overall portfolio allocation. This strategy's rigorous adherence to style consistency avoids that problem. Second, with the sector-neutral approach of Calibrated equity strategies, we reduce the vulnerability to extended periods of underperformance due to misplaced sector bets. The downside may be limiting possible outperformance from overweighting a particular sector, but we believe the combination of using a sector-neutral approach and focusing active risk on stock selection provides a platform for us to deliver more consistent outperformance.

Q. How do you know if this approach is working?
A. The ultimate proof of the process is outperforming the Russell 1000 Value Index and our peers. Though it's early for the Calibrated Large Cap Value strategy [and past performance is not a guarantee or reliable indicator of future results], it's reassuring that it is in the first percentile of the peer group since launch and that it is outperforming the index by nearly 400 basis points [as of December 31, 2012]. In addition, when looking at performance attribution, the source of nearly all of that outperformance is stock selection—exactly as we would have expected.