2020, Study Session # 10, Reading # 24

Active Equity Investing Strategies

1. INTRODUCTION

Two broad approaches to active equity investing strategies are fundamental & quantitative.
The objective of both approaches is to outperform a passive benchmark.

2. APPROACHES TO ACTIVE INVESTMENT

Differences between Fundamental and Quantitative approaches

Style Decision Primary Information Analysis Orientation Portfolio

making process Resources used Focus to data Construction
Fundamental Subjective Discretionary Human Research Conviction in Forecasting Use judgement
judgment skills stock, sector, views
or region
Qualitative Objective Systematic Statistical Data & Variables Historical Use optimizers
Modeling skills statistics data

2.1 2.2 2.3 2.4

Differences in the Nature Constitutions When Index Construction Factor-Based
of the Information Used Choosing a Benchmark Methodologies Strategies
Index

Bottom-up fundamental Fundamental: Fundamental: Fundamental:

investors assess a company • in depth analysis on using knowledge, judgment, • major risk is at company level
using its recent financial few stocks. in-depth analysis as stocks are usually high-
statements and disclosures • take large positions conviction stocks.
for attributes e.g, in selected stocks. Quantitative • Manager monitor portfolio
profitability, leverage, to predict future returns by holdings continuously
identify trends and Quantitative: analyzing historical data
company’s future prospects. • focus on factors using models Quantitative
across a large group • Major risk is that factor
Top-down fundamental of stocks. returns may not perform as
investors’ research starts by • selected factor bets expected.
analyzing region, sector, are spread across a • Portfolios are usually
economic or macro trends. large number of rebalanced at regular
stocks. intervals.
Quantitative approaches use
historical data and statistical
techniques to identify
variables that are statistically
significant with the stock
returns.

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 2020, Study Session # 10, Reading # 24

3. TYPES OF ACTIVE MANAGEMENT STRATEGIES

3.1 3.2 3.3 3.4 3.5

Bottom-Up Top-Down Factor-Based Activist Other
Strategies Strategies Strategies Portfolios Strategies Strategies

Bottom-up fundamental investors focus on Style Factors 1) Strategies Based on Statistical

• analyst’s in-depth knowledge to identify • Value- stocks with low P/E or Arbitrage and Market Microstructure
companies with strong or weak high earnings yield Data commonly used include stock
fundamentals. • Price momentum – stocks that price, dividend, trading volume, limit
• one or more of the following three are winners over a certain order book
parameters: period
i) business model and branding • Growth - company’s growth Analytical tools used include:
ii) competitive advantages potential • Traditional technical analysis
iii) company management and • Quality - company’s • Sophisticated time-series
corporate governance fundamental measures analysis and econometric
Bottom-up strategies are broadly classified as: models
i) value-based approaches - investors Unconventional Factors Based on • Machine-learning techniques
tend to buy stocks trading at a Unstructured Data
significant discount to their estimated The rapid growth in technology 2) Event Driven Strategies exploit
intrinsic value. and computational algorithms market inefficiencies related to
• Relative Value has resulted in investors corporate events such as M&As,
• Contrarian Investing embracing big data earnings or restructuring
• High quality investing announcements, share buybacks,
• Income investing special dividends, and spinoffs.
• Deep value investing
• Restructuring and Distressed Top-down investors focus on variables Activist investors take stakes in target companies
Investing such as macroeconomic factors, and advocate changes for the purpose of
• Special Situations demographic trends, government producing a gain on the investment.
ii) growth-based approaches - investors policies. The Popularity of Shareholder Activism
focus on • Country & Geographic Allocation The popularity and viability of shareholder
• high-quality companies that are to Equities activism is also influenced by:
expected to grow faster than • Sector and Country Rotation • legal frameworks in different jurisdictions,
their industry or overall market. • Volatility-Based Strategies • shareholder structures, and
• companies with high price • Thematic Investment Strategies • cultural considerations
multiples. Tactics Used by Activist Investors
Portfolio Overlays: A Portfolio overlay • Seeking board representation
GARP (growth at a reasonable price) is a set of derivative positions • Engaging with management
• is a hybrid of growth and value managed separately from the • Proposing corporate changes
investing. portfolio to attain overall portfolio • Launching legal proceedings against

/ characteristics. existing management for breach of
• PEG ratio = .
 
   fiduciary duties
• Launching a media campaign against
existing management practices
• Breaking up a large conglomerate to
unlock value
Typical Activist Targets
On average, target companies feature slower
revenue, earnings growth than the market, suffer
negative share price momentum, and have
weaker-than-average corporate governance.

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 2020, Study Session # 10, Reading # 24

4. Creating a Fundamental Active Investment Strategy

4.1 4.2
The Fundamental Active Pitfalls in Fundamental
Investment Process Investing

4.2.1 4.2.2
Steps followed by fundamental investors in Behavioral Bias Value & Growth Traps
the process:
• Define the investment universe.
• Prescreen the investment universe for
further analysis.
• Identify company and business of screened • Confirmation Bias • The value trap
stocks. • Illusion of Control • The growth trap
• Forecast company performance. • Availability Bias
• Convert forecasts to valuations • Loss Aversion Bias
• Construct a portfolio of identified • Overconfidence Bias
investment • Regret Aversion Bias
• Rebalance the portfolio

5. Creating a Quantitative Active Investment Strategy

5.1 5.2
Creating a Quantitative Pitfalls in Quantitative
Investment Process Investment Processes

5.1.1 5.1.2 5.1.3 5.1.4 5.1.5

Defining the Acquiring and Back-testing Evaluating Portfolio
Market Processing the the Strategy the Strategy Construction Issues
Opportunity Data in Quantitative
(Investment Investment
Thesis)

quantitative Involves mapping Back-testing strategy is

active investors data from different represents a evaluated using
believe that sources, building simulation of real- out-of-sample
back-tests. • Survivorship Bias • Turnover
market is not databases,
understanding data
life investing. • Look-ahead Bias • Transaction
efficient.
availability, cleaning • Data Mining Costs
up the data, and • Overfitting • Short
reshaping data into a Availability
usable format.

Risk models
5.1.3.1 5.1.3.2 Trading costs
Information Creating a
Coefficient Multifactor Model

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6.1.1
Holdings-Based
Approaches
Holdings-based
approaches are done
bottom-up but executed
differently by various
commercial information
providers
6.1.1.1
Large-cap, Mid-
Cap, and Small-cap
Classifications
Size classification is
determined using
company’s market
capitalization. There is no
standardization of the
criteria used for size
classification.
2020, Study Session # 10, Reading # 24
6. Equity Investment Style Classification
6.1 6.2
Different Strengths and
Approaches to Style Limitations of Style
Classifications Analysis
6.1.2 6.1.3 Strengths
Returns-Based Manager Self- • accuracy
Style Analysis Identification • ability to identify contribution of
individual holding to the style
• visibility of styles
fund’s investment Weaknesses
Is used when managers do • may generate inaccurate results if
strategy in described
not disclose full details of input data is limited or there are
the fund’s flaws in the application design.
their holdings by using
prospectus and can • results within certain boundaries
statistical tools to identify
be interpreted as the may cause difficulty to detect
the style indices
manager’s self- aggressive positions.
Fund returns =
 =  + identification of the
∑   investment style.
  +  + 
6.1.1.2
Measuring
Growth, Value and
Core Characteristics
Equity style analysis assigns a
style score to each stock.
A simple value scoring model
uses one factor.
Comprehensive models use
multiple factors, assign a fixed
weight to each factor, and
generate a value score.
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