Quantitative Equity Investing: Techniques and Strategies (The Frank J. Fabozzi Series)

530 Pages·2010·3.82 MB·English

by  Frank J. Fabozzi CFA

QUANTITATIVE EQUITY INVESTING FABOZZI $95.00 USA/$114.00 CAN
THE FRANK J. FABOZZI SERIES
FOCARDI
FRANK J. FABOZZI is Professor in the Practice Techniques and strategies for successful KOLM In 1952, Harry Markowitz introduced a critical
of Finance and Becton Fellow at the Yale School of innovation in investment management—popularly
quantitative equity management
Management and Editor of the Journal of Portfolio referred to as modern portfolio theory—in which
Q
Management. He is a Chartered Financial Analyst he suggested that investors should decide the allocation
and earned a doctorate in economics from the City U of their investment funds on the basis of the trade-off
University of New York. Quantitative equity portfolio management is a fundamental A between portfolio risk, as measured by the standard
SERGIO M. FOCARDI is Professor of Finance building block of investment management. This hands-on guide N deviation of investment returns, and portfolio return, as
measured by the expected value of the investment return.
at EDHEC Business School in Nice and a closes the gap between theory and practice by presenting state-of- T Entire new research areas grew from his groundbreaking
founding partner of the Paris-based consulting
the-art quantitative techniques and strategies for managing equity I idea, which, with the spread of low-cost powerful
firm The Intertek Group. He is also a member T
computers, found important practical applications in
of the Editorial Board of the Journal of Portfolio portfolios. A
several fi elds of fi nance. Developing the necessary inputs
Management. Sergio holds a degree in electronic
T for constructing portfolios based on modern portfolio
engineering from the University of Genoa and a
Authors Frank Fabozzi, Sergio Focardi, and Petter Kolm—all of I theory has been facilitated by the development of
PhD in mathematical finance from the University V
Bayesian statistics, shrinkage techniques, factor models,
of Karlsruhe as well as a postgraduate degree whom have extensive experience in this area—address the essential E and robust portfolio optimization. Modern quantitative
in communications from the Galileo Ferraris
elements of this discipline, including fi nancial model building, techniques have now made it possible to manage large
Electrotechnical Institute (Turin). E
investment portfolios with computer programs that look
fi nancial engineering, static and dynamic factor models, asset
PETTER N. KOLM is the Deputy Director of the Q for the best risk-return trade-off available in the market.
Mathematics in Finance Master’s Program and allocation, portfolio models, transaction costs, trading strategies, U
This book shows you how to perform quantitative
Clinical Associate Professor of Mathematics at and much more. They provide numerous illustrations and thorough I equity portfolio management using these modern
the Courant Institute of Mathematical Sciences, T
discussions of implementation issues facing those in the investment techniques. It skillfully presents state-of-the-art
New York University; and a founding Partner of Y
advances in the theory and practice of quantitative
the New York–based financial consulting firm the management business and include the necessary background material equity portfolio management. Page by page, the
Heimdall Group, LLC. Previously, Petter worked in fi nancial econometrics to make the book self-contained. For many IN Q expert authors—who have all worked closely with
in the Quantitative Strategies Group at Goldman UANTITATIVE
hedge fund and quantitative asset management
Sachs Asset Management. He received an MS in of the advanced topics, they also provide the reader with references V
fi rms—cover the most up-to-date techniques, tools,
mathematics from ETH in Zurich; an MPhil in E
to the most recent applicable research in this rapidly evolving fi eld. and strategies used in the industry today.
applied mathematics from the Royal Institute of
S
Technology in Stockholm; and a PhD in applied They begin by discussing the role and use of
T E
mathematics from Yale University. In today’s fi nancial environment, you need the skills to analyze, QUITY mathematical techniques in fi nance, offering sound
I
theoretical arguments in support of fi nance as a
optimize, and manage the risk of your quantitative equity portfolio. N
rigorous science. They go on to provide extensive
This guide offers you the best information available to achieve this G background material on one of the principal tools
Jacket Illustration: Jupiter Images
used in quantitative equity management—fi nancial
goal.
ST I econometrics—covering modern regression theory,
te NVESTING applications of Random Matrix Theory, dynamic
rc
ah time series models, vector autoregressive models,
tn and cointegration analysis. The authors then look
e
gi at fi nancial engineering, the pitfalls of estimation,
q
i
eu methods to control model risk, and the modern
se theory of factor models, including approximate
s Techniques and Strategies and dynamic factor models. After laying a fi rm

a
theoretical foundation, they provide practical advice
n
on optimization techniques and trading strategies
d
based on factors and factormodels, offering a modern
view on how to construct factor models.
FRANK J. FABOZZI, SERGIO M. FOCARDI, PETTER N. KOLM
ffffiirrss..iinndddd vvii 11//66//1100 1111::4411::0066 PPMM
Quantitative
Equity
Investing
ffffiirrss..iinndddd ii 11//66//1100 1111::4411::0055 PPMM
The Frank J. Fabozzi Series
Fixed Income Securities, Second Edition by Frank J. Fabozzi
Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate
Handbook of Global Fixed Income Calculations by Dragomir Krgin
Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi
Real Options and Option-Embedded Securities by William T. Moore
Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi
The Exchange-Traded Funds Manual by Gary L. Gastineau
Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi
Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu
Handbook of Alternative Assets by Mark J. P. Anson
The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry
The Handbook of Financial Instruments edited by Frank J. Fabozzi
Collateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J. Fabozzi
Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi
Investment Performance Measurement by Bruce J. Feibel
The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi
The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz
Foundations of Economic Value Added, Second Edition by James L. Grant
Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson
Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi,
Steven V. Mann, and Moorad Choudhry
Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. Fabozzi
The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry
The Handbook of European Structured Financial Products edited by Frank J. Fabozzi and
Moorad Choudhry
The Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and
Frank J. Fabozzi
Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi
The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer
Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy
Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and
Steven V. Mann
Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and
Frank J. Fabozzi
Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M.
Focardi, and Petter N. Kolm
Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by
Frank J. Fabozzi, Lionel Martellini, and Philippe Priaulet
Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi
Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S.
Goodman, and Frank J. Fabozzi
Handbook of Alternative Assets, Second Edition by Mark J. P. Anson
Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry
Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and
Teo Jasic
Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas,
Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning
Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm,
Dessislava A. Pachamanova, and Sergio M. Focardi
Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev,
Stogan V. Stoyanov, and Frank J. Fabozzi
How to Select Investment Managers and Evaluate Performance by G. Timothy Haight,
Stephen O. Morrell, and Glenn E. Ross
Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and
Frank J. Fabozzi
Structured Products and Related Credit Derivatives by Brian P. Lancaster, Glenn M. Schultz, and
Frank J. Fabozzi
ffffiirrss..iinndddd iiii 11//66//1100 1111::4411::0066 PPMM
Quantitative
Equity
Investing
Techniques and Strategies
FRANK J. FABOZZI
SERGIO M. FOCARDI
PETTER N. KOLM
with the assistance of
Joseph A. Cerniglia and
Dessislava Pachamanova
John Wiley & Sons, Inc.
ffffiirrss..iinndddd iiiiii 11//66//1100 1111::4411::0066 PPMM
Copyright © 2010 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmit-
ted in any form or by any means, electronic, mechanical, photocopying, recording, scan-
ning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States
Copyright Act, without either the prior written permission of the Publisher, or authorization
through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222
Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web
at www.copyright.com. Requests to the Publisher for permission should be addressed to the
Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,
[phone], fax [phone], or online at http://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their
best efforts in preparing this book, they make no representations or warranties with respect
to the accuracy or completeness of the contents of this book and specifi cally disclaim any
implied warranties of merchantability or fi tness for a particular purpose. No warranty may
be created or extended by sales representatives or written sales materials. The advice and
strategies contained herein may not be suitable for your situation. You should consult with a
professional where appropriate. Neither the publisher nor author shall be liable for any loss
of profi t or any other commercial damages, including but not limited to special, incidental,
consequential, or other damages.
For general information on our other products and services or for technical support, please
contact our Customer Care Department within the United States at [phone], outside
the United States at [phone], or fax [phone].
Wiley also publishes its books in a variety of electronic formats. Some content that appears in
print may not be available in electronic books. For more information about Wiley products,
visit our web site at www.wiley.com.
Library of Congress Cataloging-in-Publication Data:
Fabozzi, Frank J.
Quantitative equity investing : techniques and strategies / Frank J. Fabozzi, Sergio M.
Focardi, Petter N. Kolm ; with the assistance of Joseph A. Cerniglia and Dessislava Pacha-
manova.
p. cm. — (The Frank J. Fabozzi series)
Includes index.
ISBN 978-0-470-26247-4 (cloth)
1. Portfolio management. 2. Investments. I. Focardi, Sergio. II. Kolm, Petter N. III. Title.
HG4529.5.F3346 2010
332.63’2042—dc22
2009050962
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
ffffiirrss..iinndddd iivv 11//66//1100 1111::4411::0066 PPMM
FJF
To my wife Donna, and my children
Francesco, Patricia, and Karly
SMF
To my mother and in memory of my father
PNK
To my wife and my daughter, Carmen and Kimberly,
and in memory of my father-in-law, John
ffffiirrss..iinndddd vv 11//66//1100 1111::4411::0066 PPMM
ffffiirrss..iinndddd vvii 11//66//1100 1111::4411::0066 PPMM
Contents
Preface xi
About the Authors xv
CHAPTER 1
Introduction 1
In Praise of Mathematical Finance 3
Studies of the Use of Quantitative Equity Management 9
Looking Ahead for Quantitative Equity Investing 45
CHAPTER 2
Financial Econometrics I: Linear Regressions 47
Historical Notes 47
Covariance and Correlation 49
Regressions, Linear Regressions, and Projections 61
Multivariate Regression 76
Quantile Regressions 78
Regression Diagnostic 80
Robust Estimation of Regressions 83
Classifi cation and Regression Trees 96
Summary 99
CHAPTER 3
Financial Econometrics II: Time Series 101
Stochastic Processes 101
Time Series 102
Stable Vector Autoregressive Processes 110
Integrated and Cointegrated Variables 114
Estimation of Stable Vector Autoregressive (VAR) Models 120
Estimating the Number of Lags 137
Autocorrelation and Distributional Properties of Residuals 139
Stationary Autoregressive Distributed Lag Models 140
vii
ffttoocc..iinndddd vviiii 11//66//1100 1111::4422::3366 PPMM
viii CONTENTS
Estimation of Nonstationary VAR Models 141
Estimation with Canonical Correlations 151
Estimation with Principal Component Analysis 153
Estimation with the Eigenvalues of the Companion Matrix 154
Nonlinear Models in Finance 155
Causality 156
Summary 157
CHAPTER 4
Common Pitfalls in Financial Modeling 159
Theory and Engineering 159
Engineering and Theoretical Science 161
Engineering and Product Design in Finance 163
Learning, Theoretical, and Hybrid Approaches to
Portfolio Management 164
Sample Biases 165
The Bias in Averages 167
Pitfalls in Choosing from Large Data Sets 170
Time Aggregation of Models and Pitfalls in the
Selection of Data Frequency 173
Model Risk and its Mitigation 174
Summary 193
CHAPTER 5
Factor Models and Their Estimation 195
The Notion of Factors 195
Static Factor Models 196
Factor Analysis and Principal Components Analysis 205
Why Factor Models of Returns 219
Approximate Factor Models of Returns 221
Dynamic Factor Models 222
Summary 239
CHAPTER 6
Factor-Based Trading Strategies I:
Factor Construction and Analysis 243
Factor-Based Trading 245
Developing Factor-Based Trading Strategies 247
Risk to Trading Strategies 249
Desirable Properties of Factors 251
Sources for Factors 251
ffttoocc..iinndddd vviiiiii 11//66//1100 1111::4422::3377 PPMM