Contents Cover Series Title Page Copyright Dedication Preface Introduction: The Birth of the Quant CHARACTERIZING THE QUANT ACTIVE VERSUS PASSIVE INVESTING Chapter 1: Desperately Seeking Alpha THE BEGINNINGS OF THE MODERN ALPHA ERA IMPORTANT HISTORY OF INVESTMENT MANAGEMENT METHODS OF ALPHA SEARCHING Chapter 2: Risky Business EXPERIENCED VERSUS EXPOSED RISK THE BLACK SWAN: A MINOR ELE EVENT—ARE QUANTS TO BLAME? ACTIVE VERSUS PASSIVE RISK OTHER RISK MEASURES: VAR, C-VAR, AND ETL SUMMARY Chapter 3: Beta Is Not “Sharpe” Enough BACK TO BETA BETA AND VOLATILITY THE WAY TO A BETTER BETA: INTRODUCING THE GFACTOR TRACKING ERROR: THE DEVIANT DIFFERENTIAL MEASURER SUMMARY Chapter 4: Mr Graham, I Give You Intelligence FAMA-FRENCH EQUATION THE GRAHAM FORMULA FACTORS FOR USE IN QUANT MODELS MOMENTUM: INCREASING INVESTOR INTEREST VOLATILITY AS A FACTOR IN ALPHA MODELS Chapter 5: Modeling Pitfalls and Perils DATA AVAILABILITY, LOOK-AHEAD, AND SURVIVORSHIP BIASES BUILDING MODELS YOU CAN TRUST SCENARIO, OUT-OF-SAMPLE, AND SHOCK TESTING DATA SNOOPING AND MINING STATISTICAL SIGNIFICANCE AND OTHER FASCINATIONS CHOOSING AN INVESTMENT PHILOSOPHY GROWTH, VALUE, QUALITY INVESTMENT CONSULTANT AS DUTCH UNCLE WHERE ARE THE RELATIVE GROWTH MANAGERS? Chapter 6: Testing the Graham Crackers … er, Factors THE FIRST TESTS: SORTING TIME-SERIES PLOTS THE NEXT TESTS: SCENARIO ANALYSIS Chapter 7: Building Models from Factors SURVIVING FACTORS WEIGHTING THE FACTORS THE ART VERSUS SCIENCE OF MODELING TIME SERIES OF RETURNS OTHER CONDITIONAL INFORMATION THE FINAL MODEL OTHER METHODS OF MEASURING PERFORMANCE: ATTRIBUTION ANALYSIS VIA BRINSON AND RISK DECOMPOSITION REGRESSION OF THE GRAHAM FACTORS WITH FORWARD RETURNS Chapter 8: Building Portfolios from Models THE DEMING WAY: BENCHMARKING YOUR PORTFOLIO PORTFOLIO CONSTRUCTION ISSUES USING AN ONLINE BROKER: FIDELITY, E*TRADE, TD AMERITRADE, SCHWAB, INTERACTIVE BROKERS, AND TRADESTATION WORKING WITH A PROFESSIONAL INVESTMENT MANAGEMENT SYSTEM: BLOOMBERG, CLARIFI, AND FACTSET Chapter 9: Barguments: The Antidementia Bacterium THE COLOSSAL NONFAILURE OF ASSET ALLOCATION THE STOCK MARKET AS A CLASS OF SYSTEMS STOCHASTIC PORTFOLIO THEORY: AN INTRODUCTION PORTFOLIO OPTIMIZATION: THE LAYMAN’S PERSPECTIVE TAX-EFFICIENT OPTIMIZATION SUMMARY Chapter 10: Past and Future View WHY DID GLOBAL CONTAGION AND MELTDOWN OCCUR? FALLOUT OF CRISES THE RISE OF THE MULTINATIONAL STATE-OWNED ENTERPRISES THE EMERGED MARKETS THE FUTURE QUANT Notes PREFACE INTRODUCTION: THE BIRTH OF QUANT CHAPTER 1: DESPERATELY SEEKING ALPHA CHAPTER 2: RISKY BUSINESS CHAPTER 3: BETA IS NOT “SHARPE” ENOUGH CHAPTER 4: MR GRAHAM, I GIVE YOU INTELLIGENCE CHAPTER 5: MODELING PITFALLS AND PERILS CHAPTER 6: TESTING THE GRAHAM CRACKERS … ER, FACTORS CHAPTER 7: BUILDING MODELS FROM FACTORS CHAPTER 8: BUILDING PORTFOLIOS FROM MODELS CHAPTER 9: BARGUMENTS: THE ANTIDEMENTIA BACTERIUM CHAPTER 10: PAST AND FUTURE VIEW Acknowledgments About the Author Index Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com Copyright © 2011 by Steven P Greiner, PhD 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 transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, 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, (978) 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978-1-118-01339-7 (ebk) Securities Investments Investment analysis Graham, Benjamin, 1894–1976 I Title HG4521.G723 2011 332.63′2042–dc22 2010039909 Fidelity Small Value Fidelity Value Fund FinAnalytica Financial engineering Financial Select Sector SPDR Fund Financial-statement data, in modeling First Quadrant Fisher, Ken Flash traders Fokker-Planck equation Forbes, Steve Ford Motor Forsythe, Greg Fortescue Metals Group Ltd FPA Fractals Frank, Barney Frechet distribution Freddie Mac Freeport-McMoran French, Ken Fundamental factors, in quant modeling Gabelli Equity Income GARCH (generalized autoregressive conditional heteroskedasticity) Garvy, Robert Gauss, Carl Gaussian copula (Li) Gaussian function See Normal (Gaussian) statistics Gaussian statistics See Normal (Gaussian) statistics GEICO General Electric (GE) Generalized autoregressive conditional heteroskedasticity (GARCH) General Motors (GM) Geode Capital Germany G-Factor Global contagion Global Industry Classification Standard (GICS) Global Wealth Report GlobeFlex GMO Google Google Finance Graham factor modeling See also Testing Graham factors art versus science of modeling Brinson attribution compilation of data from correlation matrix between factors criteria for accepting factors g-Factors hit rates low-volatility model online broker services other conditional information professional investment systems and quintile excess returns regression with forward returns relative performance of models risk decomposition Sharpe ratio standard deviation of cross-scenario returns surviving factors time-series of returns weighting factors Graham model See also Graham factor modeling; Modeling; Testing Graham factors absolute value and art versus science of modeling asset allocation basic formula basis in economic theory book to price (B/P) current ratio in dividend yield earnings growth earnings stability earnings to price (E/P) factors used in quant modeling financial-statement data in holding period IME (Industrials, Materials, and Energy) sector market capitalization portfolio development in price to book (P/B) price to earnings (P/E) trust in value traps working capital Grantham, Jeremy Great Depression Greece Greenspan, Alan Griffin, Ken Gross, Bill Growth factors, in quant modeling Growth investing Hadley, Phil Hanlong Mining Harris Investment Management Hedge funds Heteroskedasciticy High-frequency traders High quality stocks, nature of Hindsight bias, in modeling Hit rates Holding period in Graham model in modeling momentum strategy Home bias Hong Kong Hood, L Randolph HSBC Ibbotson IBM IMD IME (Industrials, Materials, and Energy) sector Immelt, Jeffrey Index tracking funds India Industry-group exposures Inefficient markets Information ratio (IR) In-sample testing, in modeling InTech Integrated Development Environment (IDE) Intel Intelligent Investor, The (Graham) Interactive Brokers International Association of Financial Engineers International Monetary Fund (IMF) Internet bubble (1999-2000) Investing: speculating versus trading versus Investment management: alpha in asset management benchmarks in consultants in modeling process history of professional investment management systems Investment philosophy, in modeling Investment Technology Group (ITG) Ito equation Japan Jiabao, Wen Jones, Michael Journal of Finance J.P Morgan Karabell, Zachary Kaufler, Matthew Kelly Criterion Kerr, William Lakonishok, Josef Laplace, Pierre Law of large numbers Legg Mason Lehman Aggregate Leptokurtosis Leuthold Group Levy-Stable distributions Li, David X Lightspeed Financial Lipper Litterman Long Term Capital Management (LTCM) Look-ahead bias, in modeling Lorentz, H A Low quality stocks, nature of LSV LTCM (Long-Term Capital Management) Lucent Technologies Lynch, Peter MACD (Moving Average Convergence) Maistre, Joseph de Malanga, Steven Mandelbrot, Benoit Manning & Napier Fund, Inc Margin-of-safety concept Market capitalization in Fama-French model in Graham model limits in benchmarks Markov random walk Markowitz, Harry Martin, R Douglas Marx, Karl Matlab Maxwell, J C MB Trading Mean Merrill Lynch Merton, Robert Mexico Mezrich, Joe Microsoft Miller, Bill Modeling See also Alpha models; Capital Asset Pricing Model (CAPM); Fama-French model; Graham factor modeling; Graham model art versus science of modeling asset allocation back-tested results bootstrapping with replacement building portfolios from models cause-and-effect examples consultants in correlation in data availability data mining data snooping financial-statement data growth investing hindsight bias holding periods home bias in-sample testing investment consultants investment philosophy in look-ahead bias multifactor models out-of-sample testing principal component analysis (PCA) quality investing relative growth managers relative value managers risk scenario testing shocking models statistical significance survivorship bias systematic measures in transparency in trust in models value investing Modern Portfolio Theory (MPT) behavioral finance and benchmarks used in regression erroneous conclusions and origins of Moivre, Abraham de Moly Mines Ltd Momentum strategies common themes in literature defensive enterprising examples of momentum measures factors used in quant modeling holding periods increasing investor interest in profitability of relation between returns and price testing momentum and earnings dispersion Morgan Stanley Morningstar Motorcycle Safety Foundation Moving Average Convergence/Divergence (MACD) MSCI MSCI-BARRA MSCI-Risk Metrics Mueller, Peter Multifactor models, in modeling My Life As a Quant (Derman) NASDAQ Navier-Stokes mathematical models Netherlands, tulipmania and Newmont Mining News Corporation Newton, Isaac Nigerian National Petroleum Corp Nixon, Richard Nomura Securities Normal (Gaussian) statistics assumptions behind criticisms of error properties and Frechet distribution versus mean value in Q-Q plots time-series plots Northfield Information Systems Numeric Investors Obama, Barack Octave S+Plus One period return Online brokers Open Application Programming Interfaces (API) Options Oracle Organisation for Economic Cooperation and Development (OECD) Out-of-sample testing, in in modeling Passive investing, active investing versus Passive risk control: active risk control versus nature of Patterson, Scott Penn West Energy Trust Pension-fund managers Petrobras Pick-Up Sticks PIMCO PNC International PNC International Equity Fund PNC Large Cap Value Fund PNC Multi-Factor SCValue Portfolios asset allocation benchmarking construction issues elements of extinction-level events (ELE) and online broker services and portfolio optimization professional investment management systems tax efficient optimization PowerShares Price to book (P/B) ratio, in Graham model Price to earnings (P/E) ratio, in Graham model Principal component analysis (PCA) Principia, The (Newton) Purposeful portfolio positioning (PPP) Putnam Growth & Income Fund Q-Group Q-Q plots Quality investing Quantitative Work Alliance for Applied Finance, Education, and Wisdom (QWAFAFEW) Quant method: characterizing computer technology and criticisms of data providers defined factors in quant modeling future and origins of types of quants Quants, The (Patterson) Rachev distributions Rand Corporation Random systems Random walk hypothesis RA (risk-aversion) parameter Rattner, Steven Ravenpack Real Estate Investment Trust (REIT) Reflexivity Regression: regression coefficient of returns against variance Regulation FD Relative growth managers Relative value managers Relativity theory (Einstein) Renaissance Technologies Return forecast (Alpha) Reuters Rio Tinto Ripley moment Risk See also Beta active versus passive alpha factors versus company versus market covariance matrix C-VAR expected tail loss (ETL) experienced versus exposed extinction-level events (ELE) Graham methodology and nature of real risk versus price fluctuations risk modeling systematic versus unsystematic value at risk (VAR) volatility and Risk budgeting Risk decomposition Risk-management quants Risk Metrics Group Rodriguez, Robert Royal Astronomical Society R programming language R-Squared Risk Management Ruby Tuesday Russell 1000 (R1K) Russell 1000 Growth (R1KG) Russell 1000 Value (R1KV) Russell 2000 (R2K) Russell 2000 Growth (R2KG) Russell 2000 Value (R2KV) Russell 3000 (R3K) Russell Mid Cap Growth index Rydex Santa Fe Institute Sarbanes-Oxley SAS Scenario analysis average excess returns over S&P 500 growth and value delineation high versus low volatility markets information ratio (IR) up and down market scenarios Scenario testing, in modeling Scholes, Myron Schwab Security Analysis (Graham and Dodd) Sell-side quants Semi-efficient markets Service Employees International Union Sharpe, William Sharpe ratio Shewhart, Walter Shocking models Siemens Simmons, Jim Simulink Singapore Sinopec (SNP) SIPDE (search, interpret, predict, decide, and execute) Six Sigma revolution Society of Quantitative Analysis Sornette, Didier Soros, George Sorting test of Graham factors S&P 100 S&P 400 S&P 500 as actively managed portfolio as benchmark comparison with Wilshire 5000 described efficient markets and volatility of S&P500 Barra Growth S&P500 Barra Value S&P 600 S&P 1500 Speculating, investing versus Spinoza, Baruch S+Plus programming language SPY Standard deviation: defined as risk measure Standard & Poor’s Depository Receipts (SPDR) State-owned enterprises (SOEs) State Street Global Advisors State Street Global Advisors ETF State Street Global Research Statistical significance, in modeling Stein, Jeremy C Stern, Andy STET Stochastic Portfolio Theory (SPT) Stock markets as chaotic systems as complex systems as complicated systems as deterministic systems discontinuity of stock prices market reflexivity as random systems SunGard-APT Survivorship bias, in modeling Systematic measures, in modeling Systematic risk See also Beta Taleb, Nassim Tax efficient optimization TD Ameritrade t-distribution Technology Select Sector SPDR Fund Templeton World Fund Testing Graham factors defining basic Graham factors factor exposures or loadings factor statistics and Sharpe ratio hit rates scenario analysis sorting stocks by factors time-series plots thinkorswim Thorp, Ed Tianjin Lishen Battery TIBCO Spotfire S+ software Time-series plots Titman, Sheridan Total Quality Management (TQM) Tracking error (TE) TradeStation Trading, investing versus Trading costs Transparency in, in modeling Treynor, Jack Trust in models T-stat Tulipmania Turnover Two Sigma Type quants: characteristics of representatives of sell-side Type quants: characteristics of as Graham-type investors representatives of risk-management quants and sell-side Type quants: characteristics of representatives of sell-side UBS U.S Securities and Exchange Commission (SEC) Universa Investments Unsystematic risk Used car pricing Valley Forge Fund Valuation factors, in quant modeling Value at risk (VAR) Value investing Value traps, in Graham model Vanguard Funds Vanguard Wellington Vanguard Windsor Variance: defined in portfolios as volatility measure Venezuela VIX See CBOE Market Volatility Index (VIX) Volatility See also Beta as factor in alpha models in Graham factor modeling as proxy for earnings stability risk and as semipredictable variance as measure of Volatility forecast Wal-Mart Weather-forecasting data Weighting factors, in Graham factor modeling Weinstein, Boas Whirlpool Wiener process Wilshire 5000 comparison with S&P 500 described Wisdom Tree Wood, Robert Working capital, in Graham model Worldcom Yahoo! Yardeni, Ed Yield curve, inverted Zweig, Jason Zweig, Marty ... in the activity of investing as an apt title for the activity as a whole We don’t call all the players of a baseball team catchers, though all of them catch baseballs, right? I make a point of. .. the management of assets Many of their quants are actuaries and focus on liabilities, so they are not of the same color as the quants previously defined Now that you know the three types of quants,... puts the portfolio manager at a disadvantage, because the assigned Morningstar benchmark is not what the manager actually uses to measure risk against nor is it what the managers design their