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Lecture 2
Fundamentals of QEPM
Seven Tenets of QEPM
• Tenet 1: Markets are mostly efficient.
• Tenet 2: Pure arbitrage opportunities do not exist.
• Tenet 3: Quantitative analysis creates statistical arbitrage
opportunities.
• Tenet 4: Quantitative analysis combines all the available
information in an efficient way.
• Tenet 5: Quantitative models should be based on sound
economic theories.
• Tenet 6: Quantitative models should reflect persistent and stable
patterns.
• Tenet 7: Deviations of a portfolio from the benchmark are
justified only if the uncertainty is small enough.
A university of Chicago
professor sees a $100 bill in
the street… What should he
do?
No Arbitrage Principle
& Efficient Market Hypothesis
• Many people are looking for profit opportunities.
• Excess profit opportunities cannot last long.
• Excess profit opportunities cannot last longer than a
few milliseconds in stock markets.
• Therefore, by the time you see an excess profit
opportunity, it must not exist any more.
Three Versions of EMH
Eugene Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,”
The Journal of Finance, 1970.
• Weak form: Trading strategies based on past prices don’t
generate excess profits
• Semi-strong form: Trading strategies based on publicly available
information don’t generate excess profits
• Strong form: Trading strategies based on public and private
information don’t generate excess profits.
Well Known Anomalies
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Value effect
Size effect
January effect
Neglected firm effect
IPO under-pricing
Index inclusion
Well Known Behavioral Biases
Ambiguity aversion
Confirmation bias
Overconfidence
Disposition effect (value loss more than
gain)
• Classification/Heuristics
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EMH & QEPM
• Tenet 1: Markets are mostly efficient.
• Tenet 2: Pure arbitrage opportunities do not exist.
• Tenet 3: Quantitative analysis creates statistical
arbitrage opportunities.
Fundamental Law of Active Management
(Grinold & Kahn)
Information Criterion & QEPM
• Tenet 4: Quantitative analysis combines all the available
information in an efficient way.
Data Mining Example #1
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100 observations on Y, X1, … X100
All variables are independent from one another
Choose the most significant variable
What would be the value of t-statistic?
Data Mining Example #2
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100 observations on Y, X1, … X100
All variables are independent from one another
Choose 10 most significant variables
What would be the value of R squared?
Three things you need to
remember about data mining
1. There is danger of data mining in almost every
empirical analysis you will perform
2. There is danger of data mining in most of empirical
analysis you will encounter
3. Avoiding data mining is very, very, very difficult
Data Mining & QEPM
• Tenet 5: Quantitative models should be based on sound
economic theories.
Parameter Stability
October. This is one of the peculiarly dangerous months
to speculate in stocks in. The others are July, January,
September, April, November, May, March, June, December,
August, and February.
— Mark Twain in Pudd'nhead Wilson (?)
Parameter Stability & QEPM
• Tenet 6: Quantitative models should reflect persistent and stable
patterns.
Parameter Uncertainty
y    x  
 ˆ , ˆ
yˆ  ˆ  ˆx
V ( yˆ )  ?
 ~ N (0,  2 )
Parameter Uncertainty & QEPM
• Tenet 7: Deviations of a portfolio from the benchmark are
justified only if the uncertainty is small enough.
Seven Tenets of QEPM
• Tenet 1: Markets are mostly efficient.
• Tenet 2: Pure arbitrage opportunities do not exist.
• Tenet 3: Quantitative analysis creates statistical arbitrage
opportunities.
• Tenet 4: Quantitative analysis combines all the available
information in an efficient way.
• Tenet 5: Quantitative models should be based on sound
economic theories.
• Tenet 6: Quantitative models should reflect persistent and stable
patterns.
• Tenet 7: Deviations of a portfolio from the benchmark are
justified only if the uncertainty is small enough.