READING 28: ACTIVE EQUITY INVESTING

MODULE 28.1 FUNDAMENTAL VS.
QUANTITATIVE APPROACHES

Fundamental approaches 👨🏽

Quantitative approaches 📐

subjective in nature, 👨 relying on analyst discretion and judgment

fewer positions in the portfolio with larger allocation 🍰

objective in nature , relying on models that generate systematic rules to select investments

focus on relationships between returns & factors across a large group of securities

Risks to the strategy lie at the individual company level if the analyst has misestimated intrinsic value / market fails to recognize the mispricing.

Risks to the strategy lie at the portfolio level if the factors do not deliver the performance as predicted by the model

🗝 The key takeaway is that when it comes to the decision to invest, fundamental investing is based more on an opinion and quantitative investing is based more on rules derived from data driven modeling

⬆: Bottom-up vs. top-down ⬇

Bottom -up

Top-down

selecting the best individual investments

use information about variables that affect many companies

use a blend of bottom-up and top-down approaches with derivatives overlay

🔶 Value based

🌳 Growth- based

Relative value / Contrarian investing/ High-quality value/
Income investing/
Deep-value investing/
Restructuring and distressed debt investing/
Special situations: divestures, spin-offs, or mergers

Consistent long-term growth
Shorter-term earnings momentum
GARP (growth at a reasonable price): PEG ratio

typically use broad market ETFs and derivatives to overweight the best markets according such dimensions:
Country/ industry/ volatility/ thematic

structured products and focused ETFs has provided managers with greater flexibility in implementing passive factor investing (sometimes referred to as smart beta products)

MODULE 28.2 TYPES OF ACTIVE
MANAGEMENT STRATEGIES 🏃

FACTOR BASED STRATEGIES

🔭 Identifying Factor Performance: The Hedged Portfolio Approach

👕 👖 Types of Style Factor

⏲ Factor Timing

ACTIVIST STRATEGIES

👣 Typical Activist Investing Process

Tactics Used by Activists

🏁 Target Companies

🤛 Impact

🖊rationale and associated processes

a variable or characteristic with which asset returns are correlated.

Rewarded factors: have a positive association with a long-term positive risk premium

Unrewarded factors: factors that do not offer a persistent return

Hedged portfolio= Long/short portfolio=long the best quantile (top smallest) & short the worst quantile (top largest) ⭐

Process to build hedged portfolio ⏳

  1. Rank the investible stock universe by the factor (e.g., for the si]e factor, rank by market cap) 💠
  1. Divide the universe into quantiles 🗂
  1. Form a long/short portfolio by going long the best quantile and shorting the worst quantile 👌
  1. The performance of this long/short portfolio is tracked over time and represents the performance of the factor ⚖

Drawbacks ❌

  1. The information in middle quantiles is lost in this approach
  1. It is assumed that the relationship between the factor and stock return is linear
  1. Portfolios can appear diversified when the manager uses multiple factors to select securities but not if the factors are highly correlated
  1. he approach assumes the manager can short stocks to create the hedged portfolio
  1. The hedged portfolio is not a ߡpure ߢfactor portfolio because it will typically have significant exposures to other risk factors

Size/ value/ momentum/ growth/ Quality / unstructured data (unconventional big data analysis)

Equity style rotation
(flexible changing style at different times)

🖊rationale and associated processes

Taking stakes >> make changes >> enhance value

Screening and analysis of activist opportunities

Buying an initial stake in the target company (typically less than 10% of voting rights).

Submitting a public proposal for changes to the company

If no agreement, threatening a proxy contest

If no agreement, launching a proxy contest

Continuing to negotiate with management

Seeking board representation

Writing open letters to management detailing the changes

Proposing changes at AGM

Proposing financial restructuring including increased dividends and share buybacks

Reducing extravagant management compensation

Launching legal proceedings against management for breach of fiduciary duties

Launching a media campaign against existing management

Breaking up a large inefficient conglomerate

Typical defenses of management

multi-class share :structures

💊 Poison pill

Staggered board provisions, which mean the board is re-elected partially each year

slower earnings / revenue growth than the market/ negative share price momentum, / weak corporate governance

improvements in growth,
profitability, and corporate governance
BUT
higher debt levels.

MODULE 28.3: OTHER STRATEGIES

Statistical Arbitrage

Event driven strategies

aim to profit from mean reversion in related share prices or by taking advantage of opportunities created by market microstructure issues ♻

Pair trading 🖇

Market microstructure-based ⏲

  1. identifies two securities in the same industry that are historically highly correlated
  2. taking advantage of a temporary breakdown in this relationship
  3. buys the underperforming security while shorting the outperforming

take advantage of
mispricing opportunities occurring due to imbalances in supply and demandthat are expected to only last for a few milliseconds

🦈M&A, earnings or restructuring announcements, share buybacks, special dividends, and spin-offs 🎊

risk arbitrage, or risk arb strategy

CREATING A FUNDAMENTAL ACTIVE
INVESTMENT STRATEGY

CREATING A QUANTITATIVE ACTIVE
INVESTMENT STRATEGY 📐

  1. Define the investment universe in accordance with the fund mandate
    (investment thesis) and explain why
  1. Prescreen the investment universe to obtain a manageable set of securities for detailed analysis
  1. Analy]e the industry, competitive position and financial reports of the companies
  1. Forecast performance, most commonly based on cash flows or earnings
  1. Convert forecasts to valuations.
  1. Construct a portfolio with the desired risk profile + Incorporate any top-down views
  1. Rebalance the portfolio as needed
  1. stock sell disciplines/
    target prices to take profits and pre-defined stop loss levels
    mitigate behavioral biases

⚠ Pitfalls

👭 Behavioral biases
confirmation bias, the illusion of control, availability bias, loss aversion, overconfidence, and regret aversion bias

Value trap ♦ ⚠
value trap is a company that is trading with low price multiples due to deteriorating fundamental business conditions

Growth trap 🌲 ⚠

  1. Define the market opportunity 👓
  1. Acquire and process data 🖐
  1. Back-test the strategy ✒
  1. Evaluate the strategy 📏
    => out-of-sample testing
  1. Construction portfolio 🏘
    (1) Risk models ❓: considering
    individual variance of positions and correlation across positions.
    (2) Trading cost 💸: explicit & implicit ( market impact cost)

Pitfalls ⚠

  1. Survivorship bias
  2. Look-ahead bias (Results from using information in the model to give trading signals at a time when the information was not available.
  3. datamining/ overfitting
  4. Turnover
  5. Lack of availability of stock to borrow
  6. Transactions cost
  7. Quant Overcrowding

MODULE 28.4 EQUITY INVESTMENT STYLE CLASSIFICATION

Returns-Based Analysis

Holdings-Based Analysis

✅Notes

An investment style classification process is designed to split a stock universe into subgroups of stocks that represent the styles discussed in this reading

🚩

  1. Stocks within a group: have a **high
    correlation** with each other
  2. correlation between groups should be lower indicating that styles are distinct sources of risk and return

🔬 looks at the attributes of each individual stock in a portfolio => to conclude the overall style of the portfolio 👕 👖

Morningstar Fund Style box Morningstar Fund style Box
https://bit.ly/2U75PPQ

  1. Allocatie by large/mid/small cap first
  1. The style box approach aims to classify approximately the same number of stocks in each of the value, blend, and growth groups
  1. Stocks would be ranked according to their dividend yield and a score allocated to a stock based on their percentile of the market value of their particular group ( i.e. large /mid/small cap)

🕶 A returns-based style analysis aims to identify the style of a fund through regression of the funds returns against a set of passive style indices

✅ Imposing a constraint:
the sum of the slope coefficients should sum to a value of 1, the slope coefficients can be interpreted as the manager's allocation to that style during the period
Return-based style analysis
Return-based styel analysis

💪 Strengths and 😩 Limitations of Style Analysis
Strength and Limitation of Style analysis
https://bit.ly/36AX7vU