The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• Two popular ways to manage equity portfolios are the traditional, or qualitative, approach and the quantitative approach.

• The equity investment process comprises four primary steps: (1) forecasting returns, risks, and transaction costs; (2) constructing portfolios that maximize expected risk-adjusted return net of transaction costs; (3) trading stocks efficiently; and (4) evaluating results and updating the process.

• There are four closely linked steps to building a quantitative equity return-forecasting model: (1) identifying a set of potential return forecasting variables, or signals; (2) testing the effectiveness of each signal, by itself and together with other signals; (3) determining the appropriate weight for each signal in the model; and (4) blending the model’s views with market equilibrium to arrive at reasonable forecasts for expected returns.

• Most quantitative equity portfolio managers use a factor risk model in which individual variances and covariances are expressed as a function of a small set of stock characteristics—such as industry membership, size, and leverage.

• Transaction costs consist of explicit costs, such as commissions and fees; and implicit costs, or market impact. The per-share cost of commissions and fees does not depend on the number of shares traded, whereas market impact costs increase on a per-share basis with the total number of shares traded.

• Tracking error measures a portfolio’s risk relative to a benchmark. Tracking ...