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 10**: **Residual 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*