Equity Management: The Art and Science of Modern Quantitative Investing, Second Edition

Foreword to First Edition by Harry M. Markowitz, Nobel Laureate

Foreword to Second Edition by Harry M. Markowitz, Nobel Laureate

Preface

Acknowledgments

INTRODUCTION
Our Approach to Quantitative Investing

PART ONE
Profiting in a Multidimensional, Dynamic World

Chapter 1
Ten Investment Insights that Matter
The Stock Market Is a Complex System
Market Complexity Can be Exploited with a Rich, Multidimensional Model
Return-Predictor Relationships Should Be Disentangled
An Investment Firm Should Abide By the Law of One Alpha
The Investment Process Should Be Dynamic and Transparent
A Customized, Integrated Investment Process Preserves Insights
Integrated Long-Short Optimization Can Provide Enhanced Returns and Risk Control for Market-Neutral and 130-30 Portfolios
Alpha from Security Selection Can Be Transported to Any Asset Class
Portfolio Optimization Should Take into Account an Investor’s Aversion to Leverage
Beware of Risk Shifting, Free Lunches, and Irrational Markets
Conclusion

Chapter 2
The Complexity of the Stock Market
The Evolution of Investment Practice
Web of Return Regularities
Disentangling and Purifying Returns
Advantages of Disentangling
Evidence of Inefficiency
Value Modeling in an Inefficient Market
Risk Modeling versus Return Modeling
Pure Return Effects
Anomalous Pockets of Inefficiency
Empirical Return Regularities
Modeling Empirical Return Regularities
Bayesian Random Walk Forecasting
Conclusion

Chapter 3
Disentangling Equity Return Regularities: New Insights and Investment Opportunities
Previous Research
Return Regularities We Consider
           Methodology
The Results on Return Regularities
           P/E and Size Effects
           Yield, Neglect, Price, and Risk
           Trends and Reversals
           Some Implications
January versus Rest-of-Year Returns
Autocorrelation of Return Regularities
Return Regularities and Their Macroeconomic Linkages
Conclusion

Chapter 4
On the Value of ‘Value’
Value and Equity Attributes
Market Psychology, Value, and Equity Attributes
          The Importance of Equity Attributes
Examining the DDM
          Methodology
          Stability of Equity Attributes
Expected Returns
          Naïve Expected Returns
          Pure Expected Returns
Actual Returns
          Power of the DDM
          Power of Equity Attributes
Forecasting DDM Returns
Conclusion

Chapter 5
Calendar Anomalies: Abnormal Returns at Calendar Turning Points
The January Effect
        Rationales
The Turn-of-the-Month Effect
The Day-of-the-Week Effect
        Rationales
The Holiday Effect
The Time-of-Day Effect
Conclusion

Chapter 6
Forecasting the Size Effect
The Size Effect
       Size and Transaction Costs
       Size and Risk Measurement
       Size and Risk Premiums
       Size and Other Cross-Sectional Effects
       Size and Calendar Effects
Modeling the Size Effect
       Simple Extrapolation Techniques
       Time-Series Techniques
       Transfer Functions
       Vector Time-Series Models
       Structural Macroeconomic Models
       Bayesian Vector Time-Series Models

Chapter 7
Earnings Estimates, Predictor Specification, and Measurement Error
Predictor Specification and Measurement Error
       Alternative Specifications of E/P and Earnings Trend for Screening
       Alternative Specifications of E/P and Trend for Modeling Returns
Predictor Specification with Missing Values
Predictor Specification and Analyst Coverage
       The Return-Predictor Relationship and Analyst Coverage
Summary

PART TWO
Managing Portfolios in a Multidimensional, Dynamic World

Chapter 8
Engineering Portfolios: A Unified Approach
Is the Market Segmented or Unified?
A Unified Model
A Common Evaluation Framework
Portfolio Construction and Evaluation
Engineering ‘Benchmark’ Strategies
Added Flexibility
Economies

Chapter 9
The Law of One Alpha

Chapter 10
Residual Risk: How Much Is Too Much?
Beyond the Curtain
Some Implications

Chapter 11
High-Definition Style Rotation
High-Definition Style
        Pure Style Returns
        Implications
High-Definition Management
Benefits of High-Definition Style

Chapter 12
Smart Beta versus Smart Alpha
Supported By Theory?
Active or Passive?
Forward-Looking and Dynamic?
Concentrated Risk Exposures?
Unintended Risk Exposures?
Factor Integration and Risk Control?
Turnover Levels?
Liquidity and Overcrowding?
Transparent or Proprietary?
Conclusion

Chapter 13
Smart Beta: Too Good To Be True?
Smart Beta Portfolios are Passive
Smart Beta Targets the Most Significant Return-Generating Factors
Smart Beta Portfolios are Well Diversified
Smart Beta Factors Perform Consistently
Smart Beta Portfolios Benefit from Mean-Reversion in Prices
Smart Beta Portfolios Can be Efficiently Combined
Smart Beta Benefits from Transparency
Smart Beta has Nearly Unlimited Capacity
Smart Beta Streamlines the Investment Decision Process for Investors
Smart Beta Costs Less than Active Investing
Conclusion

Chapter 14
Is Smart Beta State of the Art?

Chapter 15
Investing in a Multidimensional Market
The Market’s Multidimensionality
Advantages of a Multidimensional Approach
Conclusion

PART THREE
Expanding Opportunities with Market-Neutral Long-Short Portfolios

Chapter 16
Long-Short Equity Investing
Long-Short Equity Strategies
Societal Advantages of Short-Selling
Equilibrium Models, Short-Selling, and Security Prices
Practical Benefits of Long-Short Investing
Portfolio Payoff Patterns
Long-Short Mechanics and Returns
Theoretical Tracking Error
Advantages of the Market-Neutral Strategy over Long Manager plus Short Manager
Advantages of the Equitized Strategy over Traditional Long Equity Management
Implementation of Long-Short Strategies: Quantitative versus Judgmental
Implementation of Long-Short Strategies: Portfolio Construction Alternatives
Practical Issues and Concerns
       Shorting Issues
       Trading Issues
       Custody Issues
       Legal Issues
       Morality Issues
What Asset Class Is Long-Short?
Conclusion

Chapter 17
20 Myths About Long-Short

Chapter 18
The Long and Short on Long-Short
Building a Market-Neutral Portfolio
A Question of Efficiency
Benefits of Long-Short
Equitizing Long-Short
Trading Long-Short
Evaluating Long-Short

Chapter 19
Long-Short Portfolio Management: An Integrated Approach
Long-Short: Benefits and Costs
      The Real Benefits of Long-Short
      Costs: Perception versus Reality
The Optimal Portfolio
      Neutral Portfolios
      Optimal Equitization
Conclusion

Chapter 20
Alpha Transport with Derivatives
Asset Allocation or Security Selection
Asset Allocation and Security Selection
Transporter Malfunctions
Matter-Antimatter Warp Drive
To Boldly Go

PART FOUR
Expanding Opportunities with Enhanced Active 130-30 Portfolios

Chapter 21
Enhanced Active Equity Strategies: Relaxing the Long-Only Constraint in the Pursuit of Active Return
Approaches to Equity Management
Enhanced Active Equity Portfolios
       Performance: An Illustration
       The Enhanced Prime Brokerage Structure
       Operational Considerations
       Comparison to Other Long-Short Strategies
Conclusion
Appendix: Weighted-Average Capitalization Weights

Chapter 22
20 Myths About Enhanced Active 120-20 Strategies

Chapter 23
Enhanced Active Equity Portfolios Are Trim Equitized Long-Short Portfolios
Market-Neutral, Equitized, and Enhanced Active Portfolios
Trimming an Equitized Portfolio
Enhanced Active versus Equitized Portfolios
Benchmark Index Choices
Conclusion

Chapter 24
On the Optimality of Long-Short Strategies
Portfolio Construction and Problem Formulation
Optimal Long-Short Portfolios
      Optimality of Dollar Neutrality
      Optimality of Beta Neutrality
      Optimal Long-Short Portfolio with Minimum Residual Risk
      Optimal Long-Short Portfolio with Specified Residual Risk
Optimal Equitized Long-Short Portfolio
      Optimality of Dollar Neutrality with Equitization
      Optimality of Beta Neutrality with Equitization
      Optimal Equitized Long-Short Portfolio with Specified Residual Risk
      Optimal Equitized Long-Short Portfolio with Constrained Beta
Conclusion

PART FIVE
Optimizing Portfolios with Short Positions

Chapter 25
Trimability and Fast Optimization of Long-Short Portfolios
General Mean-Variance Problem
Long-Short Constraints in Practice
Diagonalized Models of Covariance
      Factor Models
      Scenario Models
      Historical Covariance Models
Modeling Long-Short Portfolios
Applying Fast Techniques to the Long-Short Model
     Trimability
     Consequences of Trimability
Example
Summary

Chapter 26
Portfolio Optimization with Factors, Scenarios, and Realistic Short Positions
The General Mean-Variance Problem
Solution to the General Problem
Diagonalizable Models of Covariance
      Factor Models
      Scenario Models
      Historical Covariance Matrices
Short Sales in Practice
Modeling Short Sales
Solution to Long-Short Model
Example
Summary

PART SIX
Optimizing Portfolios for Leverage-Averse Investors

Chapter 27
Leverage Aversion and Portfolio Optimality
Optimal Enhancement with Leverage Aversion
An Example with Leverage Aversion
Conclusion

Chapter 28
Leverage Aversion, Efficient Frontiers, and the Efficient Region
Specifying the Leverage-Aversion Term
Specification of the Leverage-Aversion Term Using Portfolio Total Volatility
Optimal Portfolios with Leverage-Aversion Based on Portfolio Total Volatility
Efficient Frontiers With and Without Leverage Aversion
Efficient Frontiers for Various Leverage-Tolerance Cases
The Efficient Region
Conclusion
Appendix: Comparison of the Enhancement Surfaces Using Two Different Specifications

Chapter 29
Introducing Leverage Aversion into Portfolio Theory and Practice

Chapter 30
A Comparison of the Mean-Variance-Leverage Optimization Model and the Markowitz General Mean-Variance Portfolio Selection Model
Leverage Risk—A Third Dimension
Quartic versus Quadratic Optimization
Practical Insights from the MVL Optimization Model
Conclusion

Chapter 31
Traditional Optimization is Not Optimal for Leverage-Averse Investors
Mean-Variance Optimization with a Leverage Constraint
The Leverage-Averse Investor’s Utility of Optimal Mean-Variance Portfolios
Mean-Variance-Leverage Optimization versus Leverage-Constrained Mean-Variance Optimization
Conclusion

Chapter 32
The Unique Risks of Portfolio Leverage: Why Modern Portfolio Theory Fails and How to Fix It
The Limitations of Mean-Variance Optimization
Mean-Variance Optimization with Leverage Constraints
Mean-Variance-Leverage Optimization
Optimal Mean-Variance-Leverage Portfolios and Efficient Frontiers
The Mean-Variance-Leverage Efficient Region
The Mean-Variance-Leverage Efficient Surface
Optimal Mean-Variance-Leverage Portfolios versus Optimal Mean-Variance Portfolios
Volatility and Leverage in Real-Life Situations
Conclusion

PART SEVEN
Shifting Risk Can Lead to Financial Crises

Chapter 33
Option Pricing Theory and its Unintended Consequences

Chapter 34
When Seemingly Infallible Arbitrage Strategies Fail

Chapter 35
Momentum Trading: The New Alchemy

Chapter 36
Risk Avoidance and Market Fragility
Insuring Specific versus Systematic Risk
Insurance and Systemic Risk
Risk Sharing versus Risk Shifting

Chapter 37
Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis
Risk-Shifting Building Blocks
     RMBSs
     ABCP, SIVs, and CDOs
     CDSs
What Goes Up…
     The Rise of Subprime
      Low Risk for Sellers and Buyers
     High Risk for the System
…Must Come Down
     Positive Feedback’s Negative Consequences
     Fault Lines
Conclusion: Building From the Ruins

PART EIGHT
Simulating Security Markets

Chapter 38
Financial Market Simulation
Types of Dynamic Models
JLM Simulator
      Status
      Events
          Initialization
          Reoptimization
          Order Review
          End of Day
Objectives and Extensions
     Alternative Investor and Trader Behaviors
     Model Size
Advantages of Asynchronous Finance Models
Caveat
Conclusion

Chapter 39
Simulating Security Markets in Dynamic and Equilibrium Modes
Simulation Overview
Dynamic Analysis
      Different Initial Random Seeds
      Different Ratios of Momentum to Value Investors
      Trading and Anchoring Rules
            Trading rules
            Anchoring rules
Capital Market Equilibrium
     Expected Return Estimation Method
     Case Study
Conclusion

Index

The classic guide to quantitative investing—expanded and updated for today’s increasingly complex markets

From Bruce Jacobs and Ken Levy—two pioneers of quantitative equity management— the go-to guide to stock selection has been substantially updated to help you build portfolios in today’s transformed investing landscape.

A powerful combination of in-depth research and expert insights gained from decades of experience, Equity Management, Second Edition includes 24 new peer-reviewed articles that help leveraged long-short investors and leverage-averse investors navigate today’s complex and unpredictable markets.

Retaining all the content that made an instant classic of the first edition—including the authors’ innovative approach to disentangling the many factors that influence stock returns, unifying the investment process, and integrating long and short portfolio positions—this new edition addresses critical issues. Among them--

• What’s the best leverage level for long-short and leveraged long-only portfolios?
• Which behavioral characteristics explain the recent financial meltdown and previous crises?
• What is smart beta—and why should you think twice about using it? 
• How do option-pricing theory and arbitrage strategies lead to market instability?
• Why are factor-based strategies on the rise?

Equity Management provides the most comprehensive treatment of the subject to date. More than a mere compilation of articles, this collection provides a carefully structured view of modern quantitative investing. You’ll come away with levels of insight and understanding that will give you an edge in increasingly complex and unpredictable markets.

Well-established as two of today’s most innovative thinkers, Jacobs and Levy take you to the next level of investing. Read Equity Management and design the perfect portfolio for your investing goals.