1 INTRODUCTION Two broad approaches to active equity investing strategies are fundamental and quantitative The objective of both approaches is to outperform a passive APPROACHES TO ACTIVE INVESTMENT Active investing strategies are divided into two categories fundamental and quantitative Fundamental approaches tend to involve human judgment and are often stated as ‘discretionary’ Fundamental approaches are based on research into companies, industries, sectors or markets and use valuation models such as (free cash flow models), quantitative screening tools, statistical techniques (such as, a regression analysis) Fundamental approach often starts with the analysis of company’s financial statements to comprehend company’s profitability, financial position, cash flows This approach attempts to find company’s future business outlook by examining the company’s business model, product lines, management competence, economic viewpoint The intrinsic value of the stock is then estimated and compared to the peer group or the stock’s own historical values Based on these valuations, the decision is made concerning whether to buy or sell the stock or overweight/underweight relative to the benchmark The valuation process of fundamental analysis can be classified as top-down or bottom-up depending on their starting point Top down approach starts by analyzing markets, industries, or economies whereas bottom-up approach begins with individual stocks to identify opportunity Quantitative approaches make use of rules-based quantitative models and are often stated as ‘systematic’ Quantitative approaches rely on computer programs to develop models that have predictive power to recognize market or security features and patterns to identify securities that are expected to earn higher returns relative to the benchmark These approaches use variables that relate to company fundamentals Variables may include: • • • • • • benchmark, however, both approaches tend to make investment decisions differently valuation metrics (e.g., earning yield) size (e.g., market capitalization) profitability metrics (e.g., return on equity) financial strength metrics (e.g., debt-to-equity ratio) market sentiment (e.g., analyst consensus) industry membership (e.g., stock’s GICS classification) • price-related attributes (e.g., price momentum) Investment success of this approach depends on the model quality i.e how accurately the model predicts future expected returns of securities Note: The labels fundamental and quantitative are confusing in the sense that both approaches use quantitative tools and models Some hybrid approaches combine elements of fundamental and quantitative approaches Differences between Fundamental and Quantitative approaches Differences between Fundamental and Quantitative approaches Fundamental Qualitative Style Subjective Objective DecisionDiscretionary Systematic making process Primary Human Statistical Resources judgment skills Modeling skills Information Research Data & statistics used (company, industry, economy) Analysis Conviction in Variables Focus stock, sector, or (applying region-based over a number selection of securities) Orientation Forecasting Drawing to data views on conclusions companies & from a variety corporate of historical parameters data Portfolio Use judgement Use optimizers Construction within acceptable risk parameters Reference: CFA Institute’s Curriculum, Reading 28, Exhibit –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com.All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Active Equity Investing Strategies Reading 28 Reading 28 2.1 Active Equity Investing Strategies Differences in the Nature of the Information Used Typical activities for investors using fundamental approaches (bottom-up or top down) and quantitative approaches are given below Bottom-up fundamental investors assess a company using its recent financial statements and disclosures for attributes such as profitability, leverage, absolute or relative valuation to identify trends, to scrutinize management’s competence and the company’s future prospects FinQuiz.com Top-down fundamental investors’ research typically begins by analyzing region, sector, economic or macro trends Quantitative approaches use historical data and statistical techniques Usually, the data is processed systematically to identify variables that are statistically significant with the stock returns Historical data for quantitative research should use original accounting data and should include stocks that no longer exist to minimize look-ahead and survivorship biases Investment Process: Fundamental vs Quantitative 2.2 Difference in the Focus of the Analysis Fundamental investors typically perform in depth analysis on a small group of stocks Take large positions in selected stocks Quantitative investors focus on factors across a large group of stocks Spread their selected factor bets across large number of holdings Difference in Orientation to the Data: Forecasting the future vs Analyzing the Past Fundamental approach intends to make investment decisions by forecasting future parameters (e.g future earnings, cash flows, growth, company’s outlook) using knowledge, judgment, in-depth analysis 2.3 Quantitative approach intends to predict future returns by analyzing historical data using models (i.e backtesting past data), considering analysts’ reports about future earnings estimates that have been published Differences in Portfolio Construction: Judgement vs Optimization Fundamental investors’ major risk is at company level as stocks are usually high-conviction stocks Stock selection process involve extensive research on individual companies however risk may exist that analyst’s earnings or fair value estimates are incorrect, or market fails to recognize reasons for mispriced stocks Manager monitor portfolio holdings continuously i.e increase or decrease positions at any time 2.4 Quantitative investors’ risk is that factor returns may not perform as expected The risk lies at portfolio level as the approach invests in larger group of holdings To control Active Equity Investing Strategies Reading 28 risk at portfolio level, this approach applies portfolio optimization i.e selecting the best portfolio out of set of portfolios FinQuiz.com Practice: Example 1, CFA Curriculum, Volume 4, Reading 28 Portfolios are usually rebalanced at regular intervals TYPES OF ACTIVE MANAGEMENT STRATEGIES Equity investors have established different procedures or may take into account multiple approaches to formulate their opinions about stocks Many fundamental and quantitative strategies can be categorized as either bottom-up or top-down 3.1 Bottom-Up Strategies Bottom-up investing begins the asset selection process by focusing on attributes such as price momentum, profitability at the individual stocks Bottom-up quantitative investors use computer programs to apply their models to the asset or company-level information, which is usually quantifiable Bottom-up fundamental investors rely on analyst’s indepth knowledge and ability to identify companies with strong or weak fundamentals Then the analysts consider economic & financial elements to evaluate the selected companies’ intrinsic value and compare them with their current market prices to identify under or overvalued stocks Analysts may find operationally efficient (inefficient) companies with healthy (poor) future outlook belonging to deteriorating (booming) industries Fundamental investors focus on one or more of the following three parameters: • • • business model and branding competitive advantages company management and corporate governance Business Model and Branding: Business model refers to the company’s overall strategy to run business and generate profits Business model analysis provides insight about the company’s operations, structure of the value chain, branding strategy, market segments, business scalability etc Such information help investors in forming opinions about the company’s competitive advantages and sustainability advantage such as approach to natural resources, technology, innovation, competent workforce, reputation, brand name, high barriers to entry, superior product etc Investors should explore sustainable competitive advantage for a company’s long-term success, especially value investors who select companies trading below their intrinsic value Company Management A competent management maximizes the growth of enterprise value for the company’s shareholders Indicators that measure the management’s performance include return-on-assets, equity, invested capital, earnings growth etc Qualitative evaluation of the company’s management and governance structure include: • • • • Management’s interest towards minimizing agency issues Management’s competence to achieve longterm objectives Management’s stability and retention of highperforming executives Managing ESG considerations and related risks and opportunities Bottom-up fundamental investors value stocks by applying single or combination of approaches such as discounted cash-flow, dividend models, or earningsrelated valuation metrics i.e P/E, price to book, EV/EBITDA Bottom-up strategies are broadly classified as: i) ii) value-based approaches growth-based approaches Corporate branding serves to define company’s identity and its promises to customers Strong brand names allow companies to charge price premiums 3.1.1.) Value-Based Approaches Value-based investors tend to buy stocks trading at a significant discount to their estimated intrinsic value Value-based investors exploit opportunities may arise as a result of other investors’ irrational behaviors e.g overreaction to negative news Some value-based approaches are given below Competitive Advantages: Competitive advantage is a superiority a company has over its peers There are many types of competitive 3.1.1.1.) Relative Value Investors following relative-value approaches compare a company’s multiple to that of the average value of Reading 28 Active Equity Investing Strategies the sector Some common value indicators are P/E, P/B, current ratio, P/CF, D/E, dividend yield etc Average valuation multiples may vary for different sectors 3.1.1.2.) Contrarian Investing Contrarian investors tend to go against the crowd by buying and selling shares in contrast to the prevailing market sentiment Contrarian purchase poorly performing stocks trading below their intrinsic value with the expectation that their stock prices will rebound later, resulting in a price appreciation Contrarian investors just like value investors purchase(sell) shares trading at discount(premium) to their intrinsic value The main difference is that the contrarian investors rely on market sentiments and sharp price movements instead of fundamental metrics FinQuiz.com with high price multiples if they find growth prospects attractive GARP (growth at a reasonable price) also referred as hybrid of growth and value investing is a sub-category of growth investing GARP investors search for aboveaverage growth companies trading at reasonable valuation multiples PEG ratio calculated as !/# $%&$'($) $+,-.-/ /,01(2 ,+($ Practice: Example and 3, CFA Curriculum, Volume 4, Reading 28 3.2 Top-Down Strategies 3.1.1.3.) High-Quality Value High-quality value investment style considers financial strength, earnings power and top-class management in addition to valuation Top-down investment process begins at macro level Top-down investors focus on variables such as macroeconomic factors, demographic trends, government policies Top down managers often use instruments such as futures contracts, ETFs, swaps and custom baskets of individual stocks 3.1.1.4.) Income Investing Income investing approach target shares with high dividend yields and positive dividends growth rates Historically high dividend paying stocks have been relatively more stable 3.2.1) Country and Geographic Allocation to Equities Investors following this strategy invest in various geographic regions or countries based on the regions’ prospects Managers following this strategy analyze supply and demand for equities in different countries 3.1.1.5.) Deep-Value Investing Deep-value investors look for shares selling at extremely discounted prices e.g., shares of financially distressed companies (low P/B) This approach is for experts who understand their strategy well 3.2.2) Sector and Country Rotation This strategy is based on investor’s view on the expected returns of different sectors and industries on global basis Some industries are suitable to global sector allocation decisions e.g IT industry, energy sectors whereas other sectors or industries are appropriate for sector allocation within a country e.g real estate or consumer staples etc 3.1.1.6.) Restructuring and Distressed Investing Restructuring investors purchase debt or equity of a distressed company at a large discount with an aim to gain control over a company and then restructure it to restore the company’s intrinsic value Distressed investors tend to identify companies heading into distress that still have sufficient assets upon liquidation 3.1.1.7.) Special Situations Investors following ‘special situations’ investment style tend to recognize opportunities (often short-term) arise as a result of corporate situations such as divestitures, spinoffs of assets or divisions, mergers This investment style requires skill and expertise in identifying pertinent company 3.1.2.) Growth-Based Approaches Growth-based investors focus on high-quality companies that are expected to grow faster than their industry or overall market analyzed by growth in earnings, revenues or cash flows, above average return on equity Growth investors generally look for are companies with consistent growth or companies with strong earnings momentum Growth investors may invest in companies Some managers implement sector and industry rotation strategy by investing in sector and industry ETFs instead of buying individual stocks of pertinent industries or sectors 3.2.3) Volatility-Based Strategies Investors using this strategy form portfolios based on their views on volatility usually through derivative instruments Skill and expertise are required to predict future market volatility better than option-implied volatility For example, an investor who anticipates high index volatility but is not sure about the direction, can capitalize on his view by entering into a long index straddle (buying call and put option with the same strike price and expiry date) 3.2.4) Thematic Investment Strategies Thematic investors discover investment strategies based on some new or promising ideas or themes using macroeconomic, demographic, political drivers or bottom-up ideas on industries or sectors It is imperative for thematic investors to observe whether the nature of trend or any new change is structural (that Active Equity Investing Strategies Reading 28 have long-term impacts on market such as growth of smartphones, tablets, cloud computing, development in medicine etc.) or short-term (such as short-term view on currency movements) Portfolio Overlays: A Portfolio overlay is a set of derivative positions managed separately from the portfolio to attain overall portfolio characteristics Bottom-up strategists often control unintended macro risk exposures through portfolio overlays Portfolio overlays are also used to enhance active returns that are uncorrelated with the underlying portfolio strategy 3.3 Factor-Based Strategies A factor is any variable with which individual asset returns are correlated They represent variables which can be used to rank stocks for investment and predict future returns & risk Factors can be classified as rewarded factors – such as, value, style, momentum, and profitability, which offer a persistent return premium – or unrewarded factors – not offer a persistent return premium A factor-based strategy aims to identify factors which can predict stock returns and constructs portfolios which tilts towards those factors Factor-based strategies can employ a single factor or multiple factors Portfolio managers who use strategies that are based on new or innovative factors often rely on academic research Using data on value and growth style indices over a 28year period, value and growth styles, which represent traditional style factors, produced the same returns with growth equities being more volatile Over the same period, small-cap stocks earned marginally higher returns than large-cap stocks but with higher risk Equity style rotation strategies – based on the belief that factors work well in some periods but not during others An investment process is used to allocate to stocks representing a style which generates positive excess return relative to the benchmark during a period Generally used as part of quantitative investing Manager may be data mining if the selection of a factor lacks common senses, i.e the factor passes statistical backtesting but there is weak evidence on its ability to produce returns in the future Step 2: Divide the universe into quantile portfolios (typically quintiles or deciles) Step 3: Weight each stock using equal-weighting or market-capitalization weighting Step 4: A long/short hedged portfolio is formed by going long the best quantile and shorting the worst quantile Step 5: Track the performance of the hedged portfolio Drawbacks of the approach: • Information contained in the bottom and top quantiles is utilized to form the hedge portfolio while information in the middle quantile is ignored • Implicit assumption that relationship between factor and future stock returns is linear (monotonic) which is unrealistic • Resulting portfolios tend to be concentrated • Hedged portfolio requires managers to short stocks which may be expensive or not possible • Portfolio is not a pure factor portfolio because it has significant exposure to other factors Factor-tilting portfolio: Used to establish a long exposure to a given factor with controlled tracking error Termed as an enhanced indexing strategy – tracks the benchmark index and provides factor exposure Factor-mimicking portfolio (FMP): • • • Step 1: Select factor (s) and rank investable stock universe stock using the factor (s) Theoretical long/short dollar-neutral portfolio with a unit exposure to one factor and no exposure to other factors Drawback of the portfolio is that it can be expensive to trade as portfolio takes long/short exposure in almost every stock without considering short availability issues or transaction costs Pure factor portfolio can be constructed by following FMP theory but adding liquidity and short availability constraints 3.3.1) Style Factors 3.3.1.1) Value Value can be measured in a number of ways: • • Hedged Portfolio Approach Most common approach to implement factor-based portfolios Portfolio is constructed as follows: FinQuiz.com Stocks with low P/E or high earnings yield provide higher returns, Basu (1977) Book-to-market ratio is a way to measure value and growth, Fama and French (1993) Why value stocks deliver superior returns: • • Value premium exists to compensate investors for the greater likelihood that such companies will experience financial distress, Fama and French (1993, 1996) The effect is a result of behavioral bias on the Reading 28 Active Equity Investing Strategies part of the investor, Lakonishok, Shleifer, and Vishny (1994) Value factors can be constructed using fundamental performance metrics as: • • • • • • • Dividends Earnings Cash flow EBIT EBITDA Sales Adjustments for industry (and/or country) and historical differences Valuation ratios can be computed using historical (trailing) or forward-looking metrics 3.3.1.2) Price Momentum Researchers found a strong price momentum effect in most asset classes in most countries According to research: • • stocks that are winners over the previous 12 months tend to outperform losers (classified as such over the past 12 months) and the outperformance persists over the next to 12 months short-term reversal effect: stocks that have high price momentum tend to underperform over the next to 12 months o this effect is attributable to behavioral biases such as overreaction to information Factors based on a company’s fundamental data include profitability, balance sheet, solvency risk, earnings quality, stability, sustainability of dividend payment, capital utilization, and management efficiency measures Earnings revision – another analyst sentiment indicator which refers to the phenomenon of analysts revising their corporate earnings estimates Analysts have now started to include cash flow revisions, sales revisions, ROE revisions, sell-side analyst stock recommendations, and target price changes as variables in the analyst sentiment category News sentiment – Investors use natural language processing (NLP) algorithms to analyze the large volume of news stories and quantify the news sentiment on stocks 3.3.2) Unconventional Factors Based on Unstructured Data The rapid growth in technology and computational algorithms has resulted in investors embracing big data – extremely large data sets that includes structured and unstructured data Examples of unstructured data include satellite images and textual information Factor based on customer-supplier chain data is one example of an unconventional factor Practice: Example 5, CFA Curriculum, Volume 4, Reading 28 3.4 Price momentum is subject to extreme tail risk Sector-neutralized price momentum factor: Factor used to reduce downside risk by removing the effect of sector exposure from price momentum factor returns Practice: Example 4, CFA Curriculum, Volume 4, Reading 28 3.3.1.3) Growth Growth factors aim to measure a company’s growth potential and can be calculated using historical growth rates or projected forward growth rates Growth factors can be short-term or long-term Higher than sector or market growth is considered an indicator of strong future stock price performance for most metrics except assets 3.3.1.4) Quality The accruals factor can be used as a style factor Based on research paper on earnings quality, stock prices were found to fail to fully reflect information contained in the accruals and cash flow components of earnings The performance of this factor is cyclical FinQuiz.com Activist Strategies Activist investors take stakes in target companies and advocate changes for the purpose of producing a gain on the investment Activists may want representation on company’s board of directors in order to initiate strategic, operational, or financial structure changes Active investors may also support activities such as cost-cutting measures or asset sales and so forth The Shareholder Activism Process: • • • • • • The process begins with investors screening companies and analyzing opportunities in the market The investor reviews companies carrying out an in-depth analysis of their business and opportunities for unlocking value Investors then buy an equity stake in the company and start advocating for change Stakes above a certain threshold must be made public in certain jurisdictions The goal of activist investing could either be a financial gain or non-financial gain Activist investors aim to achieve their goals with smaller stakes rather than a full takeover bid Reading 28 Active Equity Investing Strategies Activist’s time horizon is shorter than a buyand-hold investor but the whole process can last for several years • 3.4.1.) The Popularity of Shareholder Activism Proponents of shareholder activism argue that it is an important and necessary activity that helps discipline corporate management to the benefit of all shareholders Opponent argue that activism can cause distraction and negatively impact management performance Effectiveness of shareholder activism depends on the response of the existing management team and the tools at the team’s disposal Defense mechanisms available to hinder shareholder activism include: • • Activist hedge funds are one of the most prominent activist investors to resume their popular status following a brief period of decline during the global financial crisis These funds enjoy lighter regulation than other fund types and maintain fee structures which offer greater rewards The popularity and viability of shareholder activism is also influenced by: • • • legal frameworks in different jurisdictions, shareholder structures, and cultural considerations Shareholder activism is greatest in the US and visible in Europe Other countries have a relatively limited degree of activism due to cultural reasons and more concentrated shareholder ownership of companies 3.4.2) Tactics Used by Activist Investors Tactics used by activists to boost target company value include: • • • • • • • • • Seeking board representation and nominations Engaging with management by: o Writing letters to management calling for an explanation of suggested changes o Participating in management discussions o Private meetings with management o Launching proxy contests Proposing significant corporate changes during the annual general meeting Proposing restructuring of the balance sheet Reducing management compensation or realignment of compensation with share price performance Launching legal proceedings against existing management for breach of fiduciary duties Reaching out to the other company shareholders for executing corporate action Launching a media campaign against existing management practices Breaking up a large conglomerate to unlock value FinQuiz.com • • Multi-class share structures – a company founder’s shares are entitled to multiple votes per share Poison pill plans allowing the issuance of shares at a deep discount This causes economic and voting dilution Staggered board provisions – a portion of the board members are not elected at annual shareholder meetings Charter and bylaws provisions and announcements 3.4.3) Typical Activist Targets Activist investor look for specific characteristics when looking for a target company On average, target companies feature slower revenue, earnings growth than the market, suffer negative share price momentum, and have weaker-than-average corporate governance Refer to Pages 42-45 of Reading 28 for further information on activist investing Practice: Example 6, CFA Curriculum, Volume 4, Reading 28 3.5 Other Strategies Other strategies active portfolio managers employ to beat the benchmark index include statistical arbitrage and event-driven strategies Both strategies extensively use quantitative data and are implemented in a systematic, rule-based way but can also incorporate management judgment 3.5.1) Strategies Based on Statistical Arbitrage and Market Microstructure Statistical arbitrage strategies use statistical and technical analysis to exploit pricing anomalies Data commonly used include: • Stock price • Dividend • Trading volume • Limit order book Analytical tools used include: • Traditional technical analysis • Sophisticated time-series analysis and econometric models • Machine-learning techniques Active Equity Investing Strategies Reading 28 Portfolio managers take advantage of mean reversion in share prices or opportunities created by market microstructure issues A Statistical Arbitrage Strategy: Pairs Trading Statistical techniques are used to identify two securities which are highly correlated with each other Pairs trading takes a bet on the mean reversion in prices: When the price relationship between the two securities deviates from the long-term average and the deviation is temporary, managers go long the underperforming stock and short the outperforming stock As prices converge to the long-term average, the manager closes the trade securing a profit 3.5.2) Event Driven Strategies Strategies exploit market inefficiencies related to corporate events such as mergers and acquisitions, earnings or restructuring announcements, share buybacks, special dividends, and spinoffs Risk arbitrage associated with merger and acquisition (M&A) activity is the most common example of an event-driven strategy Two types of compensation for M&A transactions: 1) Cash-only transaction: • Acquirer purchases shares of target at a proposed price • Stock price of target < offer price until transaction completion • Difference in prices creates profit opportunity for acquirer 2) Share-for-share exchange transaction: • Acquirer uses own shares to purchase target company shares at an exchange ratio • A risk-arbitrageur purchases target shares and short-sells acquirer shares using exchange ratio • Shares of the target are used to cover acquirer’s short positions when acquisition is closed Risk of pairs trading: The price divergence is not temporary but due to structural reasons Investors use a stop-loss rule for the risk management of such trades Identifying stocks pairs can be done either by using a quantitative approach and creating models of stock prices or by using a fundamental approach to judge the two stocks whose prices should move together for quantitative reasons Many market microstructure-based arbitrage strategies in the US take advantage of the NYSE Trade and Quote database and often involve extensive analysis of the limit order book Investors with analytical tools and capabilities for high-frequency trades are in a position to profit from such very short-term price discrepancies Considerations for a risk-arbitrageur: • Practice: Example 7, CFA Curriculum, Volume 4, Reading 28 4.1 • Estimating the risk of a deal failing is challenging Deal duration must be considered to accurately estimate deal premium and decided which deal to participate in Creating a Fundamental Active Investment Strategy • The Fundamental Active Investment Process Goal of active management is to outperform a benchmark on a risk-adjusted basis net of fees and transaction costs Steps followed by fundamental investors in the process: FinQuiz.com Define the investment universe and market opportunity or investment thesis, which is the opportunity to earn an active return based on the investment mandate • Investment universe is determined by the mandate agreed on by the manager and client • Mandate defines the market segments, countries and regions in which value will be sought Investment thesis: Investors need to know what is the opportunity and why is it there o The ‘why’ can be determined by understanding economic, financial, behavioral or other rationale for a strategy’s profitability in the future Prescreen the investment universe to identify manageable securities for further analysis: • May be done using qualitative and quantitative criteria • Can be associated with a particular investment style • For example, value style managers may rule out stocks with high P/E ratios and high debtto-equity ratios Active Equity Investing Strategies Reading 28 Identify company and business of screened stocks by performing: • industry and competitive analysis and • analyzing financial reports Forecast company performance often done in terms of earnings or cash flows Convert forecasts to valuations and identify ex ante profitable investments Construct a portfolio of identified investment with the desired risk profile • Stocks with high potential versus benchmark are overweighed • Stock with low potential versus benchmark are underweighted, not held at all, or shorted Rebalance the portfolio using buy and sell disciplines • Ensure desired risk exposures and investment mandate are maintained • A stock sell discipline will enable profiting from a successful investment and timely exit from an unsuccessful investment In fundamental analysis, target stock price = fair market value of stock If actual stock price > target price: • stock is overvalued • upside potential is limited • potential for downside risk exists • managers should sell stock Target price may be revised with the arrival of new information Stock may also be sold if target price is adjusted to be lower than current market price • • subjective judgments by portfolio managers in research and analysis CFA Program Curriculum divides biases into two groups as follows: Cognitive errors - basic statistical, informationprocessing, or memory errors Emotional biases – arise spontaneously as a result of attitudes and feelings Both biases cause decisions to deviate from rational decisions of traditional finance 4.2.1.1) Confirmation Bias • • • • • Analyst must consider his/her behavioral biases when a stock continues to be held despite deteriorating fundamentals Stop-loss trigger point: Sets maximum loss for asset and is intended to limit behavioral biases by stock to be sold when the stock price touches this point Practice: Example 8, CFA Curriculum, Volume 4, Reading 28 • • • Pitfalls in Fundamental Investing • • • Common pitfalls include behavioral biases, the value trap and the growth trap 4.2.1.) Behavioral Bias Fundamental, discretionary investing and stock selection are subject to behavioral bias as they depend on A cognitive error Investors overestimate their ability to select stocks and influence outcomes Consequences of bias: Excessive trading and/or heavy weighting in selected stocks Bias can be reduced by seeking contrary viewpoints and setting and enforcing proper trading and diversification rules 4.2.1.3.) Availability Bias • 4.2 A cognitive error Analysts look for information confirming their existing beliefs on favored companies and ignores/undervalues contradictory information Also known as stock love bias known as selection bias - results in selective exposure, perception and retention Consequence of bias: poorly diversified portfolio, excessive risk exposure, and holdings in poorly performing securities Risk of bias is reduced by actively seeking opinion of others considering a range of information sources 4.2.1.2) Illusion of Control • Note: FinQuiz.com • Information-processing bias falling in the cognitive error category Probability of outcome is estimated based on information availability and how easily outcome are recalled Easily recalled outcomes are perceived as more likely than those harder to recall or understand Consequence of bias: May reduce investment opportunity set and result in insufficient diversification as manager opts for selective stocks which are familiar Bias can be reduced by conducting a disciplined portfolio analysis with a long-term focus which will eliminate any short-term emphasis caused by this bias Active Equity Investing Strategies Reading 28 4.2.1.4.) Loss Aversion Bias • • • • • Emotional bias Investors prefer avoiding losses over achieving gains Utility derived from a gain is lower than the utility given up in a loss Consequences of bias: Unbalanced portfolios are held: poorly performing positions are kept in home of recovery and successful investments are sold early to avoid risk Bias can be avoided by a disciplined trading strategy with a stop-loss rule 4.2.1.5) Overconfidence Bias • • • • • Emotional bias Investors demonstrated a high level of faith in their judgement, reasoning and/or cognitive abilities Individuals may overestimate knowledge, abilities and access to information Consequences of bias: Overestimation of expected results and underestimation of risks Bias can be avoided by regular review of actual investment records and seeking constructive feedback from other professionals 4.2.2.1.) The Value Trap A stock that appears to be attractively value with a low P/E multiple and/or low price-to-book value or price-tocash flow multiples but is overpriced given worsening future prospects A value trap appears to be an attractive investment and so investors should conduct research in a company before investment so that they understand reasons for attractive valuation An investor is likely to fall into a value trap if a company does not have any catalysts available to trigger a reevaluation of its prospects In this case, a stock is less likely to adjust to fair value 4.2.2.2) The Growth Trap Possible growth traps: • • 4.2.1.6) Regret Aversion Bias • • • • Emotional bias Investors avoid pain of regret associated with making poor decisions Consequence of bias: Investors may refrain from decision-making, hold on to positions for a long time and miss out on profitable opportunities Bias can be avoided by using a carefully defined portfolio review process – review and justify existing positions and provide evidence for a decision to avoid certain stocks FinQuiz.com Growth investors invest in stocks with the expectation of above-average earnings growth in the future If expectations are not met, company stock will underperform An overpriced stock is purchased, and the investee company may deliver aboveaverage earnings and/or cash flow growth, in line with expectations However, share price does not move higher due to its high starting level Investors are willing to pay a high price for growth stocks as they believe earnings are sustainable and earnings are likely to grow fast in the future Risks of value trap investing: • • Company’s superior market position may not be sustainable due to competitive forces Earnings may experience an initial accelerated increase only to undergo a marked slowdown subsequently 4.2.2) Value and Growth Traps Value- and growth-oriented investors face risks known as traps 5.1 Creating a Quantitative Active Investment Strategy Creating a Quantitative Investment Process Quantitative/systematic/rules-based investing generally has a structured and well-defined process The process starts with a belief or hypothesis and relies on data from a wide range of sources, data science and management to deal with missing values and outliers, and quantitative models to test the hypothesis 5.1.1) Defining the Market Opportunity (Investment Thesis) Like fundamental active investors, quantitative active investors believe that market is not efficient Fund managers use publicly available information to predict future stock returns Reading 28 Active Equity Investing Strategies 5.1.2) Acquiring and Processing the Data Involves mapping data from different sources, building databases, understanding data availability, cleaning up the data, and reshaping data into a usable format Most commonly used data in quantitative investing includes: • • • • Company mapping – used to track companies over time and across data vendors Company fundamentals – include company demographics, financial statements, and other market data Quantitative portfolio managers rely on data vendors for this data Survey data includes: o Company earnings o forecasts o estimates by market participants o macroeconomic variables o sentiment indicators o information on funds flow Unconventional data refers to unstructured data which includes: o Satellite images o Measures of news sentiment o Customer-supplier chain metrics o Corporate events 5.1.3.2) Creating a Multifactor Model Managers need to select, and weight factors included in a multifactor model and can use either qualitative or systematic processes for this purpose Factors can be weighted by 1) treating each factor as an asset or 2) using a standard mean-variance optimization Factors which may be useful individually may not add material value to the model if they are correlated with other factors 5.1.4) Evaluating the Strategy The performance of the strategy is evaluated using outof-sample back-tests in which a different set of data is used to evaluate the model’s robustness Statistics such as the t-statistic, Sharpe ratio, Sortino ratio, VAR, conditional VAR, and drawdown characteristics are used to form an opinion on the outcome of their out-ofsample back-test 5.1.5) Portfolio Construction Issues in Quantitative Investment Portfolio construction issues include: • Data is never in a format required for quantitative investing Investors needs to check data for consistency, cleaning up error and outliers, and transforming the data into a usable format • 5.1.3) Back-testing the Strategy Back-testing represents a simulation of real-life investing 5.1.3.1) Information Coefficient Factor’s information coefficient (IC) - the correlation between factor exposures and their holding period returns This is used as a measure of factor performance in quantitative back-tests An advantage of IC – aggregates information about factors from all securities in the investment universe Pearson IC – simple correlation coefficient between standardized factor exposures for the current period’s and next period’s stock returns Facts about Pearson IC: • • • Value is always between – to + The higher the IC, the higher the predictive power of the factor for subsequent returns The coefficient is sensitive to outliers Spearman rank IC is more robust and preferred This IC measure is the Pearson correlation coefficient between ranked factor scores and ranked forward returns See Exhibit 28 for an illustration of the Pearson and Spearman rank IC FinQuiz.com 5.2 Risk models: Directly estimating the variancecovariance matrix using sample return data is infeasible and suffers from significant estimation errors and managers instead rely on commercial risk model vendors for these data Trading costs – types of trading costs include direct and indirect When two stocks have similar returns and risks, the stock with the lower trading costs is preferred Pitfalls in Quantitative Investment Processes 5.2.1) Survivorship Bias, Look-ahead Bias, Data Mining and Overfitting Survivorship bias: • • • One of the most common issues affecting quantitative decision-making Back-tests which only consider companies doing business today: o ignore stocks which have left the investment universe o test only those companies which are surviving o the strategy will not invest in companies that have failed Survivorship bias leads to overoptimistic results and may cause investors to draw wrong conclusions Look-ahead bias: • Using information that was unknown or unavailable at the time the investment decision was made Active Equity Investing Strategies Reading 28 Data mining: • • FinQuiz.com Transaction costs can erode returns significantly Excessive search analysis of past financial data to discover patterns and to conform to a pre-determined model for potential use in investing Results in model overfitting Practice: Example 9, CFA Curriculum, Volume 4, Reading 28 5.2.2) Turnover, Transaction Costs, and Short Availability Back-testing is conducted assuming there is no transaction costs, constraints on turnover, or limits on the availability of long and short positions which is unrealistic Equity Investment Style Classification An investment style classification process splits the investment universe into groups with each group containing stocks with similar characteristics Returns of stocks in a group should be correlated with each other and less correlated with returns of stocks in other groups Common style characteristics in active management include: • • • • • • • • Value Growth Blend (or core) Size Price momentum Volatility Income (high yield) Earnings quality The investment style of an active equity manager provides information on source of active returns in a portfolio Modern portfolio theory advocates the efficient management of a diversified portfolio of stocks and bonds A portfolio’s risk-return profile is improved by including multiple asset classes and employing managers with different investment styles Two main approaches for evaluating a manager’s style include: a holdings-based approach and a returnsbased approach 6.1.1.) Holdings-Based Approaches Holdings-based approaches are done bottom-up but executed differently by various commercial information providers: Stock membership in an industry, sector or peer group can be used to classify investment style • Stocks can also be classified based on position (net long, net short or neutral) • Investment style classifications allows the performance of active equity managers with similar styles to be compared Comparison of manager’s active returns and positions with the right style index provides valuable information about the manager’s active strategy and approach 6.1 Different Approaches to Style Classifications Equity styles are defined by pairs of common attributes, such as value and growth, large cap and small cap, high volatility and low volatility, high dividend and low dividend, or developed markets and emerging markets Pairs need not be mutually exclusive and each pair interprets stock performance from a different perspective Morningstar and Thompson Reuters Lipper: Stock’s attribute for a specific style is if included in that style index, otherwise MSCI and FTSE Russell: Assumes a stock can have two style characteristics which co-exist, such as value and growth A multi-factor approach assigns style inclusion factors to each stock Different stock characterizations and portfolio style classifications result when using different criteria or different sources of underlying growth and value numbers 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 Though attributes may vary across the world, largecompanies may be classified as those with: • a strong market presence, Active Equity Investing Strategies Reading 28 • • good levels of information disclosure, and exclusive scrutiny by the investor community and media Compared to larger companies, smaller companies: • • • • provide more growth opportunities, are less mature, have a higher risk of failure, and have a lower degree of analyst and public scrutiny Mid-cap companies rank between large- and small-cap companies and are in a more advanced stage of development than small-cap companies but provide more growth potential than large-cap companies Note: There is no consensus on the boundaries defining large-, small- and mid-cap companies 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, such as price-to-book ratios to rank the stock Stocks with a low ranking (low P/B ratios) are classified as part of the value index while those with a high ranking are classified as part of the growth index Weighting stocks by their market capitalization will create both a growth and value index with the condition that each index must represent 50% of all the stocks for that size classification in the target universe Comprehensive models use multiple factors, assign a fixed weight to each factor, and generate a value score The value score is usually between and and a fraction 6.1.2) Returns-Based Style Analysis Holdings-based style analysis cannot be used when investment managers not disclose the full details of their holdings A returns-based analysis is used instead In a returns-based analysis, statistical tools are used to identify the style indices that provide the most significant contribution to portfolio return A constrained multivariate regression attributes fund returns to selected style indices using the expression: < 𝑟( = 𝛼 + 𝛽 + 𝑅(9 + 𝜖( 9=> Where: rt = the fund return within the period ending at time t Rst = the return of the style index s in the same period 𝛽 = the fund exposure to style s (with constraints 9 ∑< 9=> 𝛽 = 1 𝑎𝑛𝑑 𝛽 > for a long-only portfolio a= a constant often interpreted as the value added by a manager FinQuiz.com et = the residual return that cannot be explained by the styles used in the analysis Key inputs to the analysis are the historical returns for the portfolio and the returns for the style indexes Selection of style indexes is crucial as stock returns can be highly correlated with the same sector, across sectors, and across global markets The manager’s own description of his/her own style is also a good starting point Commercial investment information providers such as Thompson Reuters Lipper and Morningstar collect and analyze fund data, classifying funds into style groups 6.1.3.) Manager Self-Identification The description of the fund’s investment strategy in the fund’s prospectus is the fund’s investment objective and can be interpreted as the manager’s self-identification of the investment style Returns- or holding-based style analysis can be used to identify investment style and confirm manager’s selfidentified style Styles of equity hedge funds, equity income funds, and special sector funds can be more efficiently identified using a combination of returns- and holdings-based style analysis and manager selfidentification Some funds not easily fit into established style categories (long/short, market neutral, dedicated short bias) and the investment objective in the prospectus provides a guide on style 6.2 Strengths and Limitations of Style Analysis Compared to returns-based analysis, strengths of holdings-based analysis include: • • • more accurate as actual portfolio holdings are used managers can see how each individual holding contributes to style, verify that each style is in line with stated investment philosophy, and take any action to prevent style deviation the styles a portfolio is exposed to is visible A limitation of holdings-based analysis is that it requires the availability of all portfolio constituents as well as the style attributes of each stock in the portfolio This information may not be available for historical changes in investment styles Drawbacks of a returns-based style analysis include: • • Using statistical analysis may generate inaccurate results if input data is limited or there are flaws in the application design May limit results within certain boundaries making it difficult to detect aggressive positions, Kaplan (2011) Reading 28 Active Equity Investing Strategies Returns-based analysis can be more widely applied while holdings-based analysis allows deeper style analysis Practice: Example 10, CFA Curriculum, Volume 4, Reading 28 Practice: End of Chapter Questions, CFA Program Curriculum, Volume 4, Reading 28 FinQuiz.com ... calculated as !/# $%&$'($) $+,-.-/ /,01(2 ,+($ Practice: Example and 3, CFA Curriculum, Volume 4, Reading 28 3. 2 Top-Down Strategies 3. 1.1 .3. ) High-Quality Value High-quality value investment style considers... of sector exposure from price momentum factor returns Practice: Example 4, CFA Curriculum, Volume 4, Reading 28 3. 3.1 .3) Growth Growth factors aim to measure a company’s growth potential and can... corporate governance Refer to Pages 42-45 of Reading 28 for further information on activist investing Practice: Example 6, CFA Curriculum, Volume 4, Reading 28 3. 5 Other Strategies Other strategies