Nerds on Wall Street: Math, Machines, and Wired Markets

5.2. Active Management

Institutional equity managers often operate in exactly this way. Unlike individual investors, they will not typically plunge into a very small number of concentrated positions in the stocks they favor. They do not want to stray very far from the S&P 500 and risk major differences in performance relative to the index. Consistent, if modest, value-added performance is typically the goal. The reason for this reluctance is that many institutional sponsors are themselves held to a performance standard based on the S&P 500, and they want their portfolios managed this way.

A traditional firm doing this sort of portfolio management would have a person or a group of people assigned to each industry group. Some might separate out large companies from small and medium-sized companies as well. Traditional fund analysts will specialize in an industrial area. They will sit down and have the same sort of discussion we had about Colonel Curt and Commander Dave for each group of companies in their sector. They may not be neighbors of the CEOs, but they've probably visited the plant, seen the products, read the literature, and talked to competitors and customers.

The analysts try to synthesize their pieces of information into a decision whether to include the stock in the portfolio, and at what weight, or not to include it or to underweight it relative to its index component. The reason for this underweighting, rather than eliminating an unattractive stock completely, is ...