Jacobs Levy Equity Management

1. Bruce I. Jacobs 1. is principal of Jacobs Levy Equity Management in Florham Park, NJ . (bruce.jacobs{at}jlem.com) 2. Kenneth N. Levy 1. is principal of Jacobs Levy Equity Management in Florham Park, NJ . (ken.levy{at}jlem.com) TOPICS: [Portfolio construction][1], [factor-based

Portfolio volatility is the only source of risk in mean–variance optimality, but it fails to capture all the risks faced by leveraged portfolios. These risks include the possibility of margin calls and forced liquidations at adverse prices and losses beyond the capital invested. To recognize these risks, the authors incorporated leverage aversion into the optimization process and examined the effects of volatility and leverage aversion on optimal long–short portfolios.

Like any revolution, the options revolution that began with the publication of the Black-Scholes-Merton option pricing formula has had some unintended side effects. Of concern to all investors should be the potentially dangerous increase in market instability created by the trading strategies option sellers use to hedge their market exposures. Dynamic hedging rules that call for buying as market prices rise and selling as they fall have wreaked havoc with markets in the past and are likely to do so again in the future.

Firms that use one valuation model for their core portfolio and different models for subsets of that core may end up with multiple estimates of alpha. But as every asset has only one price, doesn't it follow that the asset should have only one mispricing? It is argued here that it hardly makes sense for a single firm to begin the investment selection process with an approach that allows for the possibility of multiple mispricings for a given stock over a given horizon.