JACOBS LEVY EQUITY RESEARCH
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Equity Management: Quantitative Analysis for Stock Selection |
Market Neutral Strategies |
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Authorized Chinese Translation from English Language Edition Published by McGraw-Hill, China Machine Press, 2006.
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BOOKS
Equity Management: Quantitative Analysis for Stock Selection, by Bruce I. Jacobs and Kenneth N. Levy, with a foreword by Harry M. Markowitz, Nobel laureate, McGraw-Hill, New York, 2000.
This book brings together the groundbreaking articles of Bruce Jacobs and Ken Levy. These introduce such key concepts as "disentangling" the sources of security returns, "engineering" portfolios to performance benchmarks, and constructing "long-short" portfolios for exploiting both winning and losing stocks. A general introduction and section introductions provide a comprehensive overview of the authors' contributions and their place in the history of modern finance. Please see the book's website: http://www.jacobslevy.com/em
Endorsements:
"This is a great compendium of Jacobs and Levy's excellent research. These articles have certainly influenced my own work, and should be considered mandatory reading for any equity investor interested in quantitative techniques."
Richard Bernstein, Five-Time Winner, Institutional Investor's All-America Research Team and Chief Quantitative Strategist, Merrill Lynch & Co.
"Not only have Bruce Jacobs and Ken Levy run a successful asset management firm for a number of years, they have been willing to share some of their insights with the investment community through their writings. This compendium of their work demonstrates how investors can combine economic and company fundamentals and qualitative factors in the investment process. While not everyone agrees with their conclusions, few would be bold enough to disregard their arguments or argue with their success."
Jon A. Christopherson, Research Fellow, Frank Russell Company
"Equity Management is a book that every serious student of stock selection and portfolio management should read and devour. Bruce Jacobs and Ken Levy are outstanding members of the small band of first-rate academics (including several Nobel laureates) who have managed with great success to implement their academic research in the real world of Wall Street. The articles in this collection present a coherent picture of the authors' path-breaking research into the numerous "anomalies" which, taken together, can be used to build a successful stock selection and portfolio construction process. Jacobs and Levy make a very strong case, both in their research and in their practice, for their proposition that by combining many factors, each of which may be individually too weak to base stock selection upon, a successful "quant" strategy can be developed. Every advanced investments student in an M.B.A. or Ph.D. program, every CFA candidate, and every portfolio manager should read this book."
David K. Whitcomb, Professor Emeritus of Finance, Rutgers University and Founder & Chief Executive Officer, Automated Trading Desk, Inc.
"As I was reading this book, I was reminded of how thought-provoking and prolific Bruce Jacobs and Ken Levy really are. Any one of these articles is deserving of an 'article of the year' award. Together, they provide an abundant source of ideas for any investor interested in winning stock selection techniques."
Brian Bruce, Editor-in-Chief, The Journal of Investing
"Normal investors commit normal cognitive errors; they confuse good stocks with good companies, and markets that have risen with markets that will rise. Jacobs and Levy, long-term students of financial markets, demonstrate how the exceptional investor can profit by taking advantage of the actions of normal investors. This is an insightful book."
Meir Statman, Glenn Klimek Professor of Finance, Leavey School of Business, Santa Clara University
"Many cooks have whipped up a recipe for quantitative investment management, but only Bruce Jacobs and Ken Levy can be said to have created a whole cuisine. The thoroughness and originality of their thinking should inspire and challenge every investment manager."
Wayne H. Wagner, Chairman, Plexus Group, Inc.
"I have long made the work of Jacobs and Levy required reading for my portfolio management class. They combine rigorous academic research with valuable insights into the real world of investment practice. Equity Management should be on the bookshelf of every serious student of the stock market today."
Edward M. Miller, Research Professor of Economics and Finance, University of New Orleans
"Jacobs and Levy have composed a virtual encyclopedia of techniques and strategies that investors can use to outperform the stock market. It is destined to take its place among the classics of the field."
Frank J. Fabozzi, Adjunct Professor of Finance, School of Management, Yale University and Editor, The Journal of Portfolio Management
"Last year has been an outstanding year for useful books that provide an insight into modern portfolio theory. One of these is Equity Management: Quantitative Analysis for Stock Selection by Bruce Jacobs and Kenneth Levy. . . Much of their work focused on the complexity of the stock market and the limitations of the idea of market efficiency. They discuss ideas such as long-short investing, which are just emerging in Australia, in considerable detail."
David Lee, Consultant to Australian, New Zealand and Asian Super Funds, in Shares & Personal Investor (Australia), August 1, 2000
“Everything from portfolio engineering, the long-short investment strategy, and data analysis for market inefficiencies—it’s all featured in this modern-day classic that’s already become required reading in academic programs.”
Financial Planning Interactive, September 29, 2002
Market Neutral Strategies, Bruce I. Jacobs and Kenneth N. Levy, editors, with a foreword by Mark Anson, John Wiley, The Frank J. Fabozzi Series, Hoboken, NJ, 2005.
Market neutral strategies have gained attention in recent years for their potential to deliver positive returns regardless of the underlying market's direction. Market Neutral Strategies provides readers with insiders' views of the risks and benefits of these strategies and how they can be implemented. The book covers long-short equity portfolios, convertible bond hedging, merger and mortgage arbitrage, and sovereign fixed-income arbitrage. Additional chapters cover the tax implications of market neutral investing for taxable and tax-exempt investors; the "transportation" of alpha from a particular market neutral strategy to other asset classes; and the failure of two notorious "market neutral" hedge funds, Askin Capital Management and Long-Term Capital Management. Please see the book's website: http://www.jacobslevy.com/mns
Endorsements:
"Market Neutral Strategies surpasses its mission. Bruce Jacobs, Ken Levy, and their contributing authors elucidate the sources of potential alpha for a breadth of strategies, as well as the origins of prior miscues. At long last there is a single volume that is a practical and comprehensive guide for investors who want to explore or to learn more about market neutral and a valuable reference for seasoned investors."
Edgar J. Sullivan, Ph.D., CFA, Managing Director, Absolute Return Strategies, General Motors Asset Management
"Jacobs and Levy have once again shown their commitment to advancing the practice of investment management by producing a comprehensive, thought-leading treatment of market neutral investing. The well selected authors provide timely guidance on what we as institutional investors are challenged to think and act upon—namely, a clear understanding of the various sources of risk, the decisions to be taken between market (beta) and active (alpha) risk, and the application of the same in the prudent allocation of risk within our portfolios."
Thomas F. Obsitnik, CFA, Investment Advisor, Pension and Benefit Investments, Eli Lilly and Company
"Many institutional investors are attracted to market neutral strategies, not only because of their impressive performance, but also because they enable investors to separate management of market risk (beta) from selection risk (alpha). In Market Neutral Strategies, an impressive line-up of respected practitioners provides an excellent overview of all major aspects of these strategies. Importantly, the book underscores that their power lies in an integrated approach and not a simple combination of long and short portfolios—a fact too often ignored. This excellent and highly relevant publication provides practical answers to practical problems, and I recommend it to every investor interested in implementing a market neutral approach."
Hans de Ruiter, Senior Portfolio Manager, ABP Investments
"Bruce Jacobs and Ken Levy's latest book addresses its subject in a characteristically clear, rigorous, and comprehensive fashion. It contains a wealth of insights about market neutral investing from a range of real-life practitioners. I would commend Market Neutral Strategies to anyone with the desire or need to gain a sound understanding of the practicalities and potential uses, advantages, and risks of this approach to investing."
Rick Harper, Chief Executive Officer, Superannuation Funds of South Australia
"Serious about market neutral investing? This is the best book to date on the nearest of kin to classic arbitrage. The authors are expert, clear, and balanced. The content is rich. The style is rigorous without being academic, and free of superfluous jargon. The autopsies of two failed hedge funds are worth the price of admission. Bruce Jacobs and Ken Levy blazed the trail for institutional market neutral investing; now they illuminate it."
Richard M. Ennis, CFA, Principal, Ennis Knupp + Associates
"As arbitrageurs move from the back office to the front page, investors must have resources to guide them. Jacobs and Levy provide a guide that is dense with information, background, and examples. They handle the complex subject of investing in markets while remaining neutral to the whims of those markets at a level the intelligent investor will understand. Moreover, they place market neutral investing in the context of alpha generation and explain its role in asset allocation. Finally, they aid the taxable and tax-exempt investor in navigating the rules of the game. This book is an important tool for maneuvering through market neutral strategies."
Leola Ross, Ph.D., CFA, Senior Research Analyst, Russell Investment Group
"At last. A comprehensive book on the challenges and opportunities in market neutral investing, and a roadmap of pitfalls that many would find only by stumbling into them. This would make a nice text for an MBA in finance, and provides a valuable reference for anyone considering investments in the market neutral arena."
Robert D. Arnott, Chairman, Research Affiliates, LLC, and Editor, Financial Analysts Journal
"Because they have little or no correlation with broad markets, market neutral strategies are sought after by investors who desire active returns that can diversify traditional investment portfolios. Market Neutral Strategies provides a comprehensive review of the risks, potential returns, and mechanics of such strategies, drawing on the theoretical and hands-on knowledge of industry experts."
Harry M. Markowitz, 1990 Nobel Laureate in Economics
"Bruce Jacobs and Ken Levy have done a masterful job of collecting information useful to market neutral investors. The presentation is clear and concise. The topics covered are wide-ranging and up to date, including the current hot topic of alpha transport. My favorite features are the unique question-and-answer sections, which provide answers to typical investor questions in an easily accessible format. Anyone who plans to invest in market neutral strategies should read this book."
Brian Bruce, Editor-In-Chief, The Journal of Investing
"This book contains intuitive, informative, and insightful discussions of major market neutral strategies. Jacobs, Levy, and the other contributors share their own rich and diverse experiences in implementing these strategies in real life. Written in plain English, the book is an invaluable resource for investment professionals dealing with hedge fund strategies."
Professor Narayan Y. Naik, Director, Centre for Hedge Fund Research and Education, London Business School
"While managing several billion dollars in equities, I became frustrated by the value that I was not allowed to add, because of long-only mandates. The quant models actually worked even better on 'dog' stocks than on 'stars,' but without short selling, the additional information was useless. Even worse were the tracking error constraints that forced me to go down with the market as it collapsed. Market Neutral Strategies will do much to promote and increase the acceptability of alternative strategies, to the benefit of all investors. As always, Bruce Jacobs and Ken Levy are clear, focused, sharp and insightful. Combine this with their plain English expositions and avoidance of esoteric theory, and you have a 'must read' for any serious investor."
Les Balzer, Professor of Finance, The University of New South Wales and Head of Research, Hedge Funds of Australia Limited
"This book is a must read for all contemplating market neutral strategies. It shows how an optimized combination of long and short positions can exploit both quantitative and qualitative insights about relative security valuations. Because many investors cannot act on negative insights by selling short, there are more opportunities on the short side. Thus those who can sell short, and who know how to integrate their short positions with their long positions, are at a major advantage."
Edward M. Miller, Research Professor of Economics and Finance, University of New Orleans
"Transparency is rare in financial markets, but you will find it in this book. Jacobs, Levy, and their coauthors are lucid in their descriptions of the benefits of market neutral strategies, and they are equally lucid in their descriptions of the risks and failures. I enjoyed Market Neutral Strategies and highly recommend it."
Meir Statman, Glenn Klimek Professor of Finance, Santa Clara University
"For decades, Bruce Jacobs and Ken Levy have provided awesome thought leadership to the financial industry in an easy-to-read format. This book continues that marvelous tradition, giving readers an insider's look at market neutral investing."
Wayne H. Wagner, Chairman, Plexus Group, Inc.
"Market Neutral Strategies illuminates for the serious investor the techniques, benefits, and risks of the various methods of market neutral investing. It also shows the many possible gains from using market neutral strategies as part of an investor's total portfolio. The insights are valuable for understanding all types of hedge funds."
Edward O. Thorp, Ph.D., Edward O. Thorp Associates, and Author of Beat the Dealer
"As Bruce I. Jacobs and Kenneth N. Levy . . . use the term . . . 'market neutral' is a broad heading that can include anything non-directional—market neutral equity . . . along with the arbitraging of government bonds, corporate convertibles, asset backed securities and the two sides of a merger . . . the authors are to be commended." Christopher Faille, "Lots of Market Neutral Trees and a Map for the Forest," HedgeWorld News (www.hedgeworld.com), November 5, 2004.
ARTICLES
As principals of Jacobs Levy Equity Management, Bruce Jacobs and Ken Levy have devoted 20 years to state-of-the-art research into security pricing, portfolio construction, and sophisticated trading techniques. Their groundbreaking work on disentangling return regularities, engineering portfolios to performance benchmarks, long-short investing and integrated optimization has been featured at professional forums such as the Institute of Chartered Financial Analysts' Continuing Education Seminars and in the pages of Institutional Investor and the Wall Street Journal.
In the 1980s, Jacobs and Levy began to publish a series of articles articulating the investment philosophy that had emerged from their research. These articles appeared in the peer-reviewed Financial Analysts Journal, Journal of Portfolio Management, and Journal of Investing, as well as in practitioner-oriented publications such as Pensions & Investments. They helped to change the course of modern money management by demonstrating that the supposedly efficient equity market offered recurring profit opportunities that could be identified and exploited to provide consistent outperformance.
Jacobs and Levy's seminal insight is that U.S. equity market returns are driven by complex combinations of company fundamentals, macroeconomic conditions, and behavioral factors, and that these effects can be detected with the use of extensive computer modeling grounded in intuitive and theoretically plausible relationships. Exploiting these relationships requires simultaneous analysis of numerous variables across a broad and diverse range of stocks; portfolio optimization and performance attribution systems that are customized to the security selection process; sophisticated trading techniques; and creative research.
The articles abstracted here are grouped into five sections that cover the range of research at Jacobs Levy Equity Management. The articles abstracted under "Security Selection" focus on the U.S. equity market as a complex system and some of the methods that can best be used to "disentangle" that complexity. Those listed under "Plan Architecture and Portfolio Engineering" touch on the scope of the security selection/portfolio construction problem, the goal of portfolio management, and the place of an individual portfolio within the investor's overall investment scheme. The articles abstracted under "Long-Short Investing" discuss the construction of portfolios, including market neutral long-short and enhanced active 120-20 portfolios, that take advantage of short selling to expand investment opportunities and enhance performance. "Portfolio Optimization Including Short Positions" contains articles that examine some of the general and specific issues that arise when constructing portfolios that have both long and short positions. "Market Simulation" delves into a new area of research—the modeling of financial markets using the asynchronous-time JLM Market Simulator.
- "The Case for Quantitative Equity Management," by Bruce I. Jacobs and Kenneth N. Levy, European Pension News, September 20, 1999. article
Quantitative equity management allows for the breadth, discipline and portfolio integrity needed to detect potential profit opportunities and to exploit them in portfolios that can offer superior returns at controlled levels of risk. - "Security Valuation in a Complex Market," by Bruce I. Jacobs and Kenneth N. Levy, Chapter 1 in T. Daniel Coggin and Frank J. Fabozzi, Eds. Applied Equity Valuation, Frank J. Fabozzi Associates, New Hope, PA, 1999.
The stock market is characterized by a complex web of interrelated return effects that form predictable patterns of mispricing across stocks and over time. Detecting these patterns requires breadth of analysis and depth of inquiry; disentangling the patterns, separating each from the effects of the others, results in more robust and predictable return-predictor relationships. - "Investment Analysis: Profiting from a Complex Equity Market," by Bruce I. Jacobs and Kenneth N. Levy, Chapter 2 in Frank J. Fabozzi, Ed., Active Equity Portfolio Management, New Hope, PA, 1998. Also in Fabozzi, Ed., Handbook of Portfolio Management, Frank J. Fabozzi Associates, New Hope, PA, 1998.
An investment approach that begins with a broad equity universe provides a coherent evaluation framework that benefits from all the insights to be garnered from a wide and diverse range of securities, including variations in price behavior across different types of stocks, and is poised to take advantage of more profit opportunities than a more segmented approach can offer. Because the effects of different sources of stock return can overlap, it is also important to disentangle the connections by examining all variables of interest simultaneously. Disentangling reduces the noise in return estimates, reveals opportunities that might otherwise remain hidden, and improves predictability. - "Earnings Estimates, Predictor Specification, and Measurement Error," by Bruce I. Jacobs, Kenneth N. Levy and Mitchell C. Krask, The Journal of Investing, Summer 1997.(1) article
Increased use of expectational data for modeling stock returns places a spotlight on the specification of predictor variables. Choices between alternative specifications of a given predictor such as E/P or earnings trend, or between different treatments of missing variables, can have wide-ranging effects on portfolio selection and quantitative modeling. The importance of predictor specification may vary depending upon the predictor, the investment strategy, and the estimation procedure used. The relationship between predictors and returns may also vary across types of stocks; for instance, the relationship may be distributed differentially across stocks by the degree of analyst coverage. - "High-Definition Style Rotation," by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Investing, Fall 1996; and abstracted in The CFA Digest, Spring 1997.(2) article
Price behavior varies across different types of stock. This suggests a strategy of rotating a portfolio's allocations across styles--growth, value, large-cap, and small--to take advantage of differential performance across different economic environments. The issue then is how to define style. A "high-definition" approach looks at many stock attributes and disentangles the effects of each. This results in a detailed map of returns to stock attributes, with the potential to provide better returns than rotation strategies based on more naïve definitions of style. - "Stock Market Complexity and Investment Opportunity," by Bruce I. Jacobs and Kenneth N. Levy, in Frank J. Fabozzi, Ed., Managing Institutional Assets, Harper Row, New York, 1990.(3)
The Efficient Market Hypothesis and the Capital Asset Pricing Model cannot represent the true complexity of security pricing. The market is not totally efficient; it is permeated by numerous price patterns that can be exploited to offer excess returns to active managers. However, these patterns are not detectable or exploitable by the CAPM, low P/E, high B/P or other simple tools. Rather, a complex market calls for the judicious application of computer power to disentangle the market's cross-currents of returns. - "The Complexity of the Stock Market," by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Fall 1989; and abstracted in The CFA Digest, Spring 1990. Also in Peter L. Bernstein and Frank J. Fabozzi, Eds., Streetwise: The Best of The Journal of Portfolio Management, Princeton University Press, Princeton, NJ, 1998.(4) article
The stock market is a complex system, somewhere between the domains of order and randomness. Ordered systems are simple and predictable, and random systems are inherently unpredictable. Simple theories do not adequately describe security pricing, nor is pricing random. Rather, the market is permeated by a web of interrelated return effects. Substantial computational power is needed to disentangle, model, and exploit these return regularities. - "Forecasting the Size Effect," by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, May/June 1989. article
Small-capitalization stocks have provided higher average returns than large-capitalization stocks, and the outperformance has been strongest in the month of January. A multifactor analysis "disentangles" the effect of firm size from related factors that may influence return, including analyst neglect, low P/E, and tax-loss selling. Disentangling reveals the January small-firm seasonal to be a mere surrogate for the rebound that follows the abatement of tax-loss selling. An analysis of the pure returns to size shows that small stocks outperform the market at some times and lag at others. The payoffs to the size effect are predictable in a broader empirical framework that incorporates macroeconomic drivers such as interest rates and industrial production. - "How Dividend Discount Models Can Be Used to Add Value," by Bruce I. Jacobs and Kenneth N. Levy, in ICFA Continuing Education: Improving Portfolio Performance With Quantitative Models, Association for Investment Management and Research, Charlottesville, VA, 1989.
The dividend discount model (DDM) appeals to investors because it is a forward-looking model grounded in fundamental analysis. The DDM, however, tends to pick up effects from related factors, such as low P/E, yield, beta, and risk. Multivariate regression including all these factors reveals that DDM's predictive power is often dwarfed by other value attributes. - "Trading Tactics in an Inefficient Market," by Bruce I. Jacobs and Kenneth N. Levy, in Wayne H. Wagner, Ed., The Complete Guide to Securities Transactions: Controlling Costs and Enhancing Performance, John Wiley, New York, 1989.
Multivariate analyses of stock price behavior detect numerous patterns that may be exploitable by investment portfolios. Among these are so-called "calendar effects"--the tendency of stock prices in general to vary in systematic ways according to the time of day, day of week, month of year, etc. These calendar anomalies are difficult to exploit because of the transaction costs involved. However, investors may be able to benefit by using calendar effects to time preconceived trades. - "Calendar Anomalies: Abnormal Returns at Calendar Turning Points," by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, November/December 1988; and abstracted in The CFA Digest, Summer 1989. article
Abnormal equity returns are associated with the turn of the year, the week and the month, as well as with holidays and the time of day. Tax-loss selling at year-end, cash flows at month-end, and negative news releases over the weekend may explain some of these return abnormalities, but human psychology offers a more promising explanation. Calendar anomalies are difficult to exploit on a stand-alone basis, because of the transactions costs that would be involved. However, an investor can schedule planned trades to take advantage of calendar-based return patterns. - "On the Value of 'Value'," by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, July/August 1988; and abstracted in The CFA Digest, Spring 1989. article
Psychological factors, "noise" trading, and fads in investment styles can cause stock prices to deviate from "fair" value, and such departures can be significant and long-lasting. In a market that is not strictly price-efficient, value as measured by a dividend discount model (DDM) is but a small part of the security pricing story. An examination of security returns over the 1982-87 period shows that a DDM strategy would have produced positive but insignificant returns. When pitted against low P/E, a DDM strategy provided a lower payoff and was significant in fewer quarters. And in a multivariate regression considering DDM simultaneously with 25 equity attributes, DDM was insignificant, while many equity attributes, including sales/price, neglect, relative strength, residual-return reversal, trends in analysts' estimates and earnings surprise, provided positive, statistically significant returns. - "Disentangling Equity Return Regularities: New Insights and Investment Opportunities," by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, May/June 1988; abstracted in The CFA Digest, Fall 1988; also translated in The Security Analysts Journal of Japan, March and April 1990.(5) article
Stock market phenomena such as the January and low-P/E effects entice investors with prospects of extraordinary returns. Most previous stock market anomaly research has focused on one or two return regularities at a time. This seminal article demonstrates that multivariate regression can provide a unified framework for "disentangling" and analyzing numerous return effects simultaneously. Disentangling purifies the effect of each anomaly, affording a clearer picture of which anomalies are "real" and which are merely proxies for other effects.
While pure payoffs may be smaller than the naïve payoffs of univariate analyses (given the independent nature of the pure effects and the proxying behavior of the naïve effects), their statistical significance is often greater. The residual reversal effect is an exception, emerging stronger in magnitude in its pure form than its naïve form, primarily because the pure measure separates out related effects such as earnings surprise. Some effects, including cash flow/price, disappear completely in their pure form. And both naïve and pure returns to beta prove inconsequential in explaining cumulative returns.
The strength and persistence of returns to such anomaly measures as trends in analysts' earnings estimates represent evidence against semi-strong market efficiency. The significant payoffs to measures such as residual reversal suggest that past prices alone do matter--that is, the market is not even weak-form efficient.
Controlling for tax-loss selling and other attributes in a multivariate framework mitigates the January seasonals exhibited by many of the naïve anomaly measures. For instance, the small size effect's January seasonal vanishes. The yield effect's January seasonal remains strong, however. Also, because long-term tax-loss selling is more powerful than short-term, investor behavior appears suboptimal. A negative January seasonal in pure returns to the relative-strength measure appears to arise from profit-taking associated with tax-gain deferral.
Returns to many attributes appear to have market-related components. For example, naïve returns to low P/E behave defensively, while pure returns to low P/E are not market-related at all. Apparently naïve returns to low P/E are proxies for related defensive effects such as the yield effect. Returns to beta, however, are strongly procyclical in both their naïve and pure forms. - "Web of 'Regularities' Leads to Opportunity," by Bruce I. Jacobs and Kenneth N. Levy, Pensions & Investments, March 7, 1988.
Some return regularities are linked to macroeconomic drivers such as inflation or exchange rates, others to the institutional structure of the market, including the tax code. Still others have psychological underpinnings. For example, the return reversal effect may be attributable to the human tendency to overreact to unexpected events. Even the dividend discount model is hostage to market psychology, with the model's effectiveness differing between up and down markets. Understanding the sources of these regularities can open the door to opportunities for investors. - "Disentangling Equity Return Regularities," by Bruce I. Jacobs and Kenneth N. Levy, in ICFA Continuing Education: Equity Markets and Valuation Methods, Association for Investment Management and Research, Charlottesville, VA, 1988.(6)
Research reveals a web of cross-sectional and time-dependent return regularities. Some are related to value attributes, some to earnings, some to stock price, and some to time. These regularities tend to be interrelated; it is important to unravel them to determine the real effect of each, independent of the "noise" created by the other effects. The resulting "pure" effects can be exploited by active management. For example, a multidimensional approach places "bets" on several anomalies simultaneously, with the strength of each bet a function of the historical strength and consistency of the anomaly. This approach can be refined by considering variations over time and/or macroeconomic drivers. - "Investment Management: Opportunities in Anomalies?" by Bruce I. Jacobs and Kenneth N. Levy, Pension World, February 1987.(7)
The small-stock effect, the low-P/E effect, the day-of-the-week effect and other systematic patterns of stock price behavior seem anomalous in the context of the Efficient Market Hypothesis. Many seem to offer opportunities for profitable active investment. It is important to realize, however, that many of these effects are interrelated; almost all of the excess return to small firms, for example, comes in the month of January. It is necessary to control for these interrelationships in order to understand and exploit the true sources of excess expected return. - "Dividends, Earnings and Stock Price," by Kenneth N. Levy, Financial Analysts Journal, November/December 1985 (letter in response to J. Ronald Hoffmeister and Edward A. Dyl, "Dividends and Share Value: Graham and Dodd Revisited," Financial Analysts Journal, May/June 1985).
The estimated value of a dollar of dividends versus a dollar of retained earnings may depend upon the models one uses, and their biases. For example, managers of "riskier" companies may opt to pay lower dividends on average in order to avoid having to cut dividends when earnings decline. The stronger the relationship between firm risk and payout, the more important dividends will appear to be according to a standard valuation model.
- "Alpha Transport With Derivatives," by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, May 1999; and abstracted in The CFA Digest, Fall 1999.(8) article
Investors can use derivatives to transport the excess returns available from the selection of securities within a given asset class or subclass to virtually any other asset class. For example, an investor can pursue the return possibilities in small-cap stocks, while using futures or a swap to neutralize exposure to the small-cap asset subclass and establish exposure to the large-cap segment. The investor can thus benefit from both the security selection opportunities in small-cap stocks and the asset class performance of large-cap stocks. Using derivatives in conjunction with market-neutral long-short portfolios can offer further performance enhancement. - "Investment Management: An Architecture for the Equity Market," by Bruce I. Jacobs and Kenneth N. Levy, Chapter 1 in Frank J. Fabozzi, Ed., Active Equity Portfolio Management, Frank J. Fabozzi Associates, New Hope, PA, 1998. Also in Fabozzi, Ed., Handbook of Portfolio Management, Frank J. Fabozzi Associates, New Hope, PA, 1998.
A blueprint of the U.S. equity market reveals three basic building blocks--a comprehensive core representing all U.S. equity issues; static style subsets, comprising large-cap growth stocks, large-cap value stocks, and small-cap stocks; and a dynamic entity reflecting differing relative performance in different market environments. Investment approaches, too, can be categorized into three groups--passive, traditional active, and engineered active. Engineered active management has the potential to provide the best match between client risk/return goals and investment returns, because it can offer consistent performance relative to the equity market core or its various subsets. - "Residual Risk: How Much is Too Much?" by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Spring 1996; and abstracted in The CFA Digest, Winter 1997. article
The optimal level of residual risk for a portfolio is the level that allows the portfolio to provide the highest expected return the manager can generate within the limits of the investor's risk tolerance parameters. As it is not always easy to determine investor risk tolerance or manager ability to add value, portfolios are often "pigeonholed" according to residual risk levels alone. "Enhanced passive" or "index-plus" portfolios, for example, are expected to offer excess returns of up to 1% at residual risk levels not to exceed 2%. But such artificial constraints as a 2% bound on residual risk can lead to selection of suboptimal portfolios. In particular, they can lead investors to assume too little risk, hence allow too little expected return, for their actual risk tolerances, or to accept less skillful managers when more highly skilled managers are available. They may also encourage suboptimal manager behavior. - "How to Build a Better Equity Portfolio," by Bruce I. Jacobs and Kenneth N. Levy, Pension Management, June 1996.
Investors in U.S. equity can choose among a variety of selection universes, from the broad core including all stocks to various style subsets. They can also choose from a variety of investment approaches, from passive to traditional active to engineered active. Investors may be able to make more informed decisions if they understand the "architecture" of investing that links selection universes and investment approaches to their potential risks and returns. - "Engineering Portfolios: A Unified Approach," by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Investing, Winter 1995; and abstracted in The CFA Digest, Summer 1996.(9) article
Many traditional equity managers focus on particular subsets of the investment universe--value or growth stocks, for example--and structure their portfolios from preselected groups. By contrast, a "unified" approach starts with a blank slate, having no built-in biases regarding any particular type of stock, and searches the widest possible stock universe and the largest number of investment variables. At the same time, it recognizes differences in stock price behavior across different types of stocks and over time, as well as possible nonlinearities in stock price response to gradations in exposure to a given variable. A unified approach to stock valuation is poised to take advantage of more information and to discover a greater number of potentially profitable investment opportunities. These opportunities are maximized by a portfolio optimization process that is customized along the same dimensions as the valuation process. This ensures a portfolio whose risks and return opportunities are balanced in accordance with the insights garnered from the unified valuation approach. Given its range and depth of coverage, a unified approach provides a firm with substantial flexibility to engineer portfolios to meet a variety of client risk/return requirements. - "The Law of One Alpha," by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Summer 1995. article
Firms that use one valuation model for their core portfolio and different models for subsets of that core may end up with multiple estimates of alpha. But as every asset has only one price, doesn't it follow that the asset should have only one mispricing? It is argued here that it hardly makes sense for a single firm to begin the investment selection process with an approach that allows for the possibility of multiple mispricings for a given stock over a given horizon. - "What's A Pension Officer to Do?" by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, March/April 1990.
Pension officers deliberating between the multitude of products available to them should apply four key criteria--the plausibility of the approach; whether the underlying concepts have been published and survived public scrutiny; the proprietary value of the insights and implementation; and the quality of the people involved. - "Broader Indexes Widen Horizons," by Kenneth N. Levy and Bruce I. Jacobs, Pensions & Investments, August 20, 1984.
The S&P 500 is not truly representative of the broader U.S. equity market. It is biased toward large-cap stocks, for example, and exhibits less earnings variability, growth and market variability than the broader universe. This has implications for passive investors in search of a proxy for the U.S. equity market return.
- "Enhanced Active Equity Strategies: Relaxing the Long-Only Constraint in the Pursuit of Active Return," by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Spring 2006.(10) article
Enhanced active equity investing relaxes the long-only constraint by permitting short sales, while maintaining full exposure to equity market return and risk. The enhanced active equity approach is facilitated by modern prime brokerage structures that allow investors to use the proceeds from short sales to purchase long positions. Freeing equity portfolios from the long-only constraint can enhance performance by permitting meaningful underweight positions that are simply not achievable in long-only portfolios. The investor can thus more fully exploit security valuation insights. - "Long-Short Equity Portfolios," by Bruce I. Jacobs and Kenneth N. Levy, Chapter 12 in Frank J. Fabozzi, Ed., Short Selling: Strategies, Risks, and Rewards, John Wiley, Hoboken, NJ, 2004.
Combining long and short positions in a single portfolio increases flexibility in pursuit of return and control of risk. This increased flexibility reflects the greater freedom to act on negative insights afforded by the ability to sell short as well as the freedom from traditional index constraints afforded by the ability to offset long and short positions. Long-short portfolios also offer increased flexibility in asset management. - "Using a Long-Short Portfolio to Neutralise Market Risk and Enhance Active Returns," by Bruce I. Jacobs and Kenneth N. Levy, Chapter 10 in Ronald A. Lake, Ed., Evaluating and Implementing Hedge Fund Strategies, third edition, Euromoney Institutional Investor PLC, London, 2003 (also in 2nd ed., 1999).
A market-neutral long-short portfolio is constructed so that the dollar amount of securities held long equals the dollar amount of securities sold short and the short positions' price sensitivity to market movements equals and offsets the long positions' sensitivity. Because the portfolio's value does not rise or fall just because the broad market rises or falls, the portfolio is said to have a beta of zero. This does not mean the portfolio is riskless; it will retain the risks associated with the selection of the individual securities held long and sold short. But, with insightful security selection, the portfolio can reap commensurate rewards. - "Controlled Risk Strategies," by Bruce I. Jacobs, in ICFA Continuing Education: Alternative Investing, Association for Investment Management and Research, Charlottesville, VA, 1998.(11)
Long-short investing is a controlled risk strategy that allows the manager to act on all of his or her investment insights without regard to benchmark constraints. Long-short is not an asset class, but a portfolio construction method in which the manager neutralizes market risk by balancing the average betas of short and long positions in the portfolio. Long-short increases the manager's flexibility to pursue return and control risk. The manager can overweight or underweight stocks by as much as his or her insights (and client risk tolerances) allow. Furthermore, the manager can use offsetting long and short positions to fine-tune overall portfolio risk. This added flexibility should be reflected in portfolio performance. Long-short portfolio performance can be "transported" to virtually any asset class. For example, a long-short portfolio can be "equitized" using stock index futures; the equitized long-short portfolio will reflect the risk and return of the broad equity market and the flexibility advantages of its long-short component. Operational considerations that need to be considered before implementing a long-short strategy include margin requirements, the size of the liquidity buffer, trading requirements, management fees, and taxes. - "The Long and Short on Long-Short," by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Investing, Spring 1997; and abstracted in The CFA Digest,
Fall 1997.(12) article
By balancing long positions in equities with short positions of roughly equal dollar amount and market sensitivity, it is possible to construct a portfolio whose return is neutralized against overall market moves. Properly constructed, using an integrated optimization process, a long-short portfolio offers advantages over long-only portfolios in enhanced flexibility to pursue return, control risk, and allocate assets. Any additional costs should not outweigh the benefits of such a strategy. - "20 Myths About Long-Short," by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, September/October 1996. article
Popular conceptions of long-short investing are distorted by a number of myths, many of which appear to result from viewing long-short from a conventional investment perspective. Long-short portfolios differ fundamentally from long-only portfolios in construction, in the measurement of their risk and return, and in their implementation costs. Furthermore, long-short portfolios allow greater flexibility in security selection, asset allocation, and overall plan structure. - "Market-Neutral Strategy Limits Risk," by Bruce I. Jacobs and Kenneth N. Levy, Pension Management, July 1995.
This is a basic primer on long-short strategies. Balancing long and short positions in a portfolio can virtually eliminate the portfolio's exposure to broad market movements. - "More on Long-Short Strategies," by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, March/April 1995 (letter in response to Richard Michaud, "Are Long-Short Equity Strategies Superior?" Financial Analysts Journal, November/December 1993 and to follow-up letter by Robert Arnott and David J. Leinweber, "Long-Short Strategies Reassessed," and Michaud's "Reply," Financial Analysts Journal, September/October 1994). article
Some argue that a long-short portfolio can improve upon the risk-return tradeoff of a long-only portfolio only if it reduces risk via the diversification benefits of a less-than-one correlation between the alphas of the long and short components. But this conclusion rests on the assumption that the long component of the long-short portfolio, the short component, and the comparable long-only portfolio are essentially identical, index-constrained portfolios. When long and short positions are chosen simultaneously, however, in an integrated optimization, the result is a single portfolio that is not constrained by index weights. With freedom from index constraints, the manager enjoys added flexibility, vis-à-vis a long-only manager, in implementing investment insights. This should translate into improved performance. - "Long/Short Equity Investing," by Bruce I. Jacobs and Kenneth N. Levy, The Journal of Portfolio Management, Fall 1993; abstracted in The CFA Digest, Winter 1994; also translated in The Security Analysts Journal of Japan, March 1994.(13) article
Investors who have the flexibility to invest both long and short can benefit from both "winners" and "losers." This will be especially advantageous if the latter--the short-sale candidates--are less efficiently priced than the winners--the purchase candidates. This is likely to be the case in markets in which investors hold diverse opinions and short selling is restricted. Short positions can be combined with long positions to create market-neutral or equitized strategies. The payoff patterns to these strategies differ; market-neutral portfolio performance is independent of the broad market, while equitizing a long-short portfolio restores exposure to market risk and return. Practical issues to be considered include restrictions on shorting, trading requirements, custody issues, and tax treatment. - "The Generality of Long-Short Equitized Strategies: A Correction," by Bruce I. Jacobs and Kenneth N. Levy, Financial Analysts Journal, March/April 1993 (letter in response to C.B. Garcia and F.G. Gould, "The Generality of Long-Short Equitized Strategies," Financial Analysts Journal, September/October 1992). article
An erroneous assumption about margin requirements gives rise to the conclusion that the maximum achievable alpha from a fully invested long-short equitized strategy is 2.48 alpha. The current initial margin requirement for each equity position in a margin account, either long or short, is 50%. The theoretical maximum alpha achievable in a long-short strategy is thus 2. Given realistic constraints on futures margins and cash requirements, the practical maximum is 1.8. - "A Long-plus-Short Market-Neutral Strategy," by Bruce I. Jacobs and Kenneth N. Levy, in ICFA Continuing Education: The CAPM Controversy: Policy and Strategy Implications for Investment Management, Association for Investment Management and Research, Charlottesville, VA, 1993.
Investors who can invest both long and short can benefit from both "winners" and "losers," gaining alpha from both sides. Furthermore, there are reasons to believe that selling short losers may have more profit potential than buying winners; this will be the case in a market characterized by diverse investor opinions and restrictions on short selling. Long and short positions can be combined in market-neutral or "equitized" portfolios; a market-neutral portfolio's performance is independent of underlying market moves, while an equitized portfolio retains exposure to the market. Any active equity management style can be implemented in long-short mode, but quantitative approaches have some advantages. Long-short strategies do not constitute a separate asset class; they can be categorized by existing asset classes, so that their fit in an overall investment program becomes apparent.
- "Trimability and Fast Optimization of Long-Short Portfolios," by Bruce I. Jacobs, Kenneth N. Levy, and Harry M. Markowitz, Financial Analysts Journal, March/April 2006. article
This paper discusses the optimization of long-short portfolios using fast algorithms that were originally designed with long-only portfolios in mind. Fast algorithms that take advantage of various models of covariance gain speed by greatly simplifying the equations. Fast algorithms currently exist for factor, scenario, or mixed factor-and-scenario models of covariance, but they generally apply only to portfolios of long positions. It is desirable to be able to apply factor and scenario models to the long-short portfolio optimization problem. We introduce the concept of "trimability" for long-short portfolios, and show that the same fast algorithms that were designed for long-only portfolios can be used, virtually unchanged, for long-short portfolio optimization, provided the portfolio is "trimable." This trimability condition usually holds in practice. - "Portfolio Optimization with Factors, Scenarios, and Realistic Short Positions," by Bruce I. Jacobs, Kenneth N. Levy, and Harry M. Markowitz, Operations Research, July/August 2005. article
This paper presents fast algorithms for calculating mean-variance efficient frontiers when the investor can sell securities short as well as buy long, and when a factor and/or scenario model of covariance is assumed. Currently, fast algorithms for factor, scenario, or mixed factor and scenario models exist, but (except for a special case of the results reported here) apply only to portfolios of long positions. Factor and scenario models are used widely in applied portfolio analysis, and short sales have been used increasingly as part of large institutional portfolios. Generally, the critical line algorithm (CLA) traces out mean-variance efficient sets when the investor's choice is subject to any system of linear equality or inequality constraints. Versions of CLA that take advantage of factor and/or scenario models of covariance gain speed by greatly simplifying the equations for segments of the efficient set. These same algorithms can be used, unchanged, for the long-short portfolio selection problem provided a certain condition on the constraint set holds. This conditional usually holds in practice. - "Long-Short Portfolio Management: An Integrated Approach," by Bruce I. Jacobs, Kenneth N. Levy, and David Starer, The Journal of Portfolio Management, Winter 1999; and abstracted in The CFA Digest, Fall 1999.(14) article
With the freedom to sell short, an investor can benefit from stocks with negative expected returns as well as from those with positive expected returns. The benefits of combining short positions with long positions in a portfolio context, however, depend critically on the way the portfolio is constructed. Only an integrated optimization that considers the expected returns, risks, and correlations of all securities simultaneously can maximize the investor's ability to trade off risk and return for the best possible performance. This holds true whether or not the long-short portfolio is managed relative to an underlying asset class benchmark. Despite the incremental costs associated with shorting, a long-short portfolio, with its enhanced flexibility, can be expected to perform better than a long-only portfolio based on the same set of insights. - "On the Optimality of Long-Short Strategies," by Bruce I. Jacobs, Kenneth N. Levy, and David Starer, Financial Analysts Journal, March/April 1998.(15) article
This article considers the optimality of portfolios not subject to short-selling constraints and derive conditions that a universe of securities must satisfy for an optimal active portfolio to be dollar neutral or beta neutral. Following the common practice of constraining long-short portfolios to have zero net holdings or zero betas is generally suboptimal. Only under specific unlikely conditions will such constrained portfolios optimize an investor's utility function. The article derives precise formulas for optimally equitizing an active long-short portfolio using exposure to a benchmark security. The relative sizes of the active and benchmark exposures depend on the investor's desired residual risk relative to the residual risk of a typical portfolio and on the expected risk-adjusted excess return of a minimum-variance active portfolio. Optimal portfolios demand the use of integrated optimizations.
- "Financial Market Simulation," by Bruce I. Jacobs, Kenneth N. Levy, and Harry M. Markowitz, The Journal of Portfolio Management, 30th Anniversary Issue, September 2004.(16) For information on the JLM Simulator, go to http://www.jacobslevy.com/jlm_simulator.htm
When they want to see how complex systems work, scientists often turn to asynchronous-time simulation, which allows processes to change sporadically over time, typically at irregular intervals. While rarely used in finance today, such models may turn out to be valuable tools for understanding how markets respond to changes in the participation rates of different types of investors, for example, or to changes in regulatory or investment policies. The asynchronous, discrete-event, stock market simulator described here allows users to create a model of the market, using their own inputs. Users can vary the numbers of investors, traders, portfolio analysts, and securities, as well as their investing and trading decision rules. Such a simulation may be able to provide a more realistic picture of complex markets.
(1)Presented at Corporate Earnings Analysis Seminar, April 1996.
(2)Presented at Rutgers University Colloquium, April 1995.
(3)Presented at the Institute for Quantitative Research in Finance (Q-Group) Seminar on "New Perspectives on Equity Valuation," Spring 1990.
(4)The Journal of Portfolio Management 15th Anniversary Issue.
(5)Financial Analysts Journal Graham and Dodd Award winner.
(6)Required CFA reading.
(7)Presented at the Berkeley Program in Finance Seminar on "The Behavior of Security Prices: Market Efficiency, Anomalies and Trading Strategies," September 1986.
(8)The Journal of Portfolio Management Special 25th Anniversary Issue.
(9)The Journal of Investing Special Technology Issue, lead article.
(10)Presented at Goldman Sachs Equity Conference on “Remodeling the Investment Process – A Progress Report and Challenges Ahead,” September 2006. Featured in “New Approach Gets Hedge Fund Returns with Traditional Risk,” by Barry B. Burr, Pensions & Investments, June 12, 2006.
(11)Required CFA reading.
(12)Presented at the Institute for Quantitative Research in Finance (Q-Group) Seminar on "Long/Short Strategies in Equities and Fixed Income," Fall 1995.
(13)Highlighted by Nobel laureate Bill Sharpe in Sharpe, Alexander and Bailey, Investments, 5th Edition, 1995.
(14)The Journal of Portfolio Management Bernstein Fabozzi/Jacobs Levy Award, Outstanding Article winner.
(15)Presented at the Society of Quantitative Analysts (SQA) Seminar on "Quantitative Approaches to Market Neutral Investing," November 1997.
(16)Presented at Carnegie Mellon University and Princeton University, September 2005.