Equity Management: Quantitative Analysis for Stock
Copyright © 2000
Bruce I. Jacobs and Kenneth N. Levy
Foreword by Harry M. Markowitz, Nobel
Authorized Chinese Translation from English Language Edition
Published by McGraw-Hill, China Machine Press, 2006.
Bruce Jacobs and Ken Levy have long been recognized as pioneers in quantitative equity management. In the 1980s, they began to publish a series of articles in the peer-reviewed
Financial Analysts Journal, Journal of Portfolio Management, and
Journal of Investing. These articles were based on the authors' own research into and experience with detecting and exploiting the recurring profit opportunities available in a supposedly "efficient" marketplace. Together, they outline an approach for selecting stocks and constructing portfolios that has the potential to deliver superior returns over time.
Equity Management collects 15 of these articles, from 1988's "Disentangling Equity Return Regularities" through 1999's "Alpha Transport with Derivatives." These are grouped into three parts that cover the range of Jacobs and Levy's investment philosophy and strategy, from selecting securities to
engineering portfolios to expanding opportunities with short selling and derivatives. New introductory material provides a perspective on the articles, placing each within the broader context of the investment body of knowledge.
The authors' approach to security selection begins with the concept of a complex market. In their view, U.S. security prices are not efficient, nor random and unpredictable. Neither, however, is the market a simple system; simple "rules" such as "buy low P/E" or "buy value" will not be able to yield consistent investment profits.
Rather, a complex market is permeated by a web of return regularities. Furthermore, these regularities are interrelated and must be "disentangled" in order to arrive at real sources of return. Disentangling requires analyzing multiple promising return-predictor relationships simultaneously. The resulting "pure" estimated returns are additive and more robust than those from simpler, one-factor analyses.
The breadth of return-predictors considered in the security selection process, as well as the depth of analysis, help to capture the complexity of market pricing. But predictors can differ across different types of stocks. This dimension of complexity is best captured by viewing the broadest possible range of stocks through a wide-angle analytical lens. This is the case when the model used for analyzing individual stocks incorporates all the information available from the broad universe of stocks. This approach offers a coherent framework for analysis and is poised to take advantage of more information than a narrower view of the market (one focusing on particular styles or segments, for example) might provide.
Maximizing the opportunities detected in the security selection process requires a disciplined approach to portfolio construction. Quantitative techniques such as optimization are best suited to ensuring that opportunities are maximized, while risks are controlled. Proprietary portfolio optimization, in which the portfolio is optimized along the same dimensions that are considered in the security selection process, can further enhance portfolio performance.
Allowing for short sales expands investment opportunities, hence has the potential to improve performance. When long and short positions are balanced, the resulting portfolio is market neutral; its performance should reflect the returns and risks of the individual constituent securities, but not the performance of the market from which those securities were selected. Long and short positions are best determined in a single, integrated optimization. This frees the portfolio from benchmark weight constraints and allows it more flexibility in the pursuit of return and control of risk.
A long-short portfolio reflects the ability of the manager to select securities. The alpha, or excess return, from this security selection can be transported (along with its associated risk) to virtually any desired asset class via the purchase of derivatives on that asset class. The investor can thus take advantage of manager skill, wherever it lies, while maintaining an asset allocation that would not ordinarily encompass the securities exploited by the skilled manager.
Together, the articles in Equity Management provide a fascinating review of the concepts that form the foundation of modern active equity management.