Enhanced Index Portfolio Construction Using Full Covariance Optimization for a Small-Capitalization Portfolio
The investment in a portfolio of small-capitalization stocks is a commit ment to the future of relatively new, unproven companies and to the uncertainties commonly associated with these companies. The small-cap stock manager must by necessity “forecast” the future of many variables for each of the companies being considered and, more importantly, must accurately assess the variability of each forecast. All the typical classes of management styles, such as fundamental analysis, technical analysis, tra ditional value and growth biases, and the more unusual mathematical/sta tistical methodology can be operative in the small-stock universe, and each can generate significant amounts of alpha. While each approach encompasses unique strengths and weaknesses, all require the forecasting and assessment of variables for an acceptable set of stocks. This discus sion focuses on the use of mathematical analysis exclusively as a man agement methodology for a small-stock portfolio and the implementation of a full-covariance approach for an enhanced index assignment.