ABSTRACT
The traditional objective of active portfolio management is to consistently deliver excess return against a benchmark index with a given amount of risk. e benchmark in question could be one of the traditional market indices, such as the Standard & Poor’s (S&P) 500 Index and the Russell 2000 Index, or a cash return, such as Treasury bill rate, or LIBOR, in the case of market-neutral hedge funds. To be successful, quantitative equity managers must rely on four key components to their investment process. First and foremost on the list is an alpha model, which predicts the relative returns of stocks within a specied investment. e second component is a risk model that estimates the risks of individual stocks and the return correlations among dierent stocks. e third piece is a portfolio construction methodology to combine both return forecasts and risk forecasts to form an optimal portfolio. Lastly, one must have the portfolio implementation process in place to execute the trades. We present the portfolio construction methodology in this chapter. Risk models, alpha models, and portfolio implementations are introduced in later chapters.
