McGraw-Hill

INTRODUCTION
Life on the Leading Edge
Prior to founding Jacobs Levy Equity Management in 1986, we
had spent 5 years managing U.S. equity portfolios at the asset management
arm of Prudential Insurance Company of America. Experience
and intuition had led us to believe that new and emerging
technologies could be used to detect profitable investment opportunities
and to exploit them for the benefit of institutional clients.
Our seminal insight was that U.S. equity market retums were .
driven by complex combinations of company fundamentals, macroeconomic
conditions, and psychological factors. That is, security
prices respond to fundamentals, such as return on equity, and to the
economic backdrop, including inflation and interest rates; but the
also respond to behavioral elements such as investors' tendencies to
overreact to news and events. As a result, the market is permeated
by a complex web of interrelated return effects. We believed de- that
tecting and exploiting these inefficiencies could lead to profitable
opportunities for investment.
We devoted the first 3 years of our new firm to developing the
tools needed to find and exploit these opportunities. We started by
modeling a broad universe of U.S. stocks, combining our leadingedge
financial research and intuition with best the available statistical
and computer technology to build a system capable of analyzing
numerous stock-specific, industry-related, market-related, and
macroeconomic forces. The variables chosen for modeling had to
capture both the concrete, fundamental characteristics of stocks and
markets and their more abstract behavioral characteristics; the
modeling process itself had to capture both differences across different
types of stocks and evolutions over time.
We were the first to analyze these numerous inefficiencies in a
multivariate framework, pioneering a proprietary process of "disentangling"
return-predictor relationships. Disentangling dows us to
examine the effect on return of individual attributes"small market
capitalization, for examp1e"controlling for the impact of other attrib
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