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

Copyright © 2017

Bruce I. Jacobs and Kenneth N. Levy

Foreword by Harry M. Markowitz, Nobel Laureate

Table of Contents

Foreword to the First Edition by Harry M. Markowitz

Foreword to the Second Edition by Harry M. Markowitz

Preface to the Second Edition

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

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

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

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

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

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

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 10Residual 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?

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

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

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?

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

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

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

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

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

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

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

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

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

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

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

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

PART EIGHT: Simulating Security Markets

Chapter 38: Financial Market Simulation

Types of Dynamic Models
JLM Market Simulator
            Status
Events
Objectives and Extensions
            Alternative Investor and Trader Behaviors
            Model Size
Advantages of Asynchronous Finance Models
Caveat

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
Capital Market Equilibrium
            Expected Return Estimation Method
            Case Study

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