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READING 28: ACTIVE EQUITY INVESTING (MODULE 28.1 FUNDAMENTAL VS. …
READING 28: ACTIVE EQUITY INVESTING
MODULE 28.1 FUNDAMENTAL VS.
QUANTITATIVE APPROACHES
Fundamental approaches :man::skin-tone-4:
subjective in nature,
:man: relying on analyst discretion and judgment
fewer positions in the portfolio with larger allocation :cake:
Risks
to the strategy lie at the individual company level if the analyst has misestimated intrinsic value / market fails to recognize the mispricing.
Quantitative approaches :triangular_ruler:
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 portfolio level if the factors do not deliver the performance as predicted by the model
:old_key: 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
:arrow_up::
Bottom-up vs. top-down
:arrow_down:
Bottom -up
selecting the best individual investments
:large_orange_diamond: Value 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
:deciduous_tree: Growth- based
Consistent long-term growth
Shorter-term earnings momentum
GARP
(growth at a reasonable price): PEG ratio
Top-down
use information about variables that affect many companies
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)
use a blend of bottom-up and top-down approaches with derivatives overlay
MODULE 28.2 TYPES OF ACTIVE
MANAGEMENT STRATEGIES
:runner:
FACTOR BASED STRATEGIES
:telescope: Identifying Factor Performance: The
Hedged Portfolio
Approach
Hedged portfolio= Long/short portfolio=long the best quantile (top smallest) & short the worst quantile (top largest) :star:
Process to build hedged portfolio :hourglass_flowing_sand:
Rank the investible stock universe by the factor (e.g., for the si]e factor, rank by market cap) :diamond_shape_with_a_dot_inside:
Divide the universe into quantiles :card_index_dividers:
Form a long/short portfolio by going long the best quantile and shorting the worst quantile :ok_hand:
The performance of this long/short portfolio is tracked over time and represents the performance of the factor :scales:
Drawbacks :red_cross:
The information in middle quantiles is lost in this approach
It is assumed that the relationship between the factor and stock return is linear
Portfolios can appear diversified when the manager uses multiple factors to select securities but not if the factors are highly correlated
he approach assumes the manager can short stocks to create the hedged portfolio
The hedged portfolio is not a ߡpure ߢfactor portfolio because it will typically have significant exposures to other risk factors
:shirt: :jeans: Types of Style Factor
Size/ value/ momentum/ growth/ Quality / unstructured data
(unconventional big data analysis)
:timer_clock: Factor Timing
Equity style rotation
(flexible changing style at different times)
:pen: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
ACTIVIST STRATEGIES
:footprints: Typical Activist Investing Process
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
Tactics Used by Activists
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
1 more item...
Typical defenses of management
multi-class share :structures
:pill: Poison pill
Staggered board provisions, which mean the board is re-elected partially each year
:checkered_flag: Target Companies
slower earnings / revenue growth than the market/ negative share price momentum, / weak corporate governance
:left-facing_fist: Impact
improvements in growth,
profitability, and corporate governance
BUT
higher debt levels.
:pen:rationale and associated processes
Taking stakes >> make changes >> enhance value
MODULE 28.3: OTHER STRATEGIES
Statistical Arbitrage
aim to profit from
mean reversion
in related share prices or by
taking advantage of opportunities
created by market microstructure issues :recycle:
Pair trading :linked_paperclips:
identifies two securities in the same industry that are historically highly correlated
taking advantage of a temporary breakdown in this relationship
buys the underperforming security while shorting the outperforming
Market microstructure-based :timer_clock:
take advantage of
mispricing opportunities occurring due to imbalances in supply and demandthat are expected to only last for a few
milliseconds
Event driven strategies
:shark:M&A, earnings or restructuring announcements, share buybacks, special dividends, and spin-offs :confetti_ball:
risk arbitrage, or risk arb strategy
CREATING A FUNDAMENTAL ACTIVE
INVESTMENT STRATEGY
Define the investment universe in accordance with the fund mandate
(investment thesis) and explain why
Prescreen the investment universe to obtain a manageable set of securities for detailed analysis
Analy]e the industry, competitive position and financial reports of the companies
Forecast performance, most commonly based on cash flows or earnings
Convert forecasts to valuations.
Construct a portfolio with the desired risk profile + Incorporate any top-down views
Rebalance the portfolio as needed
stock sell disciplines/
target prices to take profits and pre-defined stop loss levels
mitigate behavioral biases
:warning:
Pitfalls
:two_women_holding_hands: Behavioral biases
confirmation bias, the illusion of control, availability bias, loss aversion, overconfidence, and regret aversion bias
Value trap :diamonds: :warning:
value trap is a company that is trading with low price multiples due to
deteriorating fundamental
business conditions
Growth trap :evergreen_tree: :warning:
CREATING A QUANTITATIVE ACTIVE
INVESTMENT STRATEGY :triangular_ruler:
Define the market opportunity :eyeglasses:
Acquire and process data :raised_hand_with_fingers_splayed:
Back-test the strategy :fountain_pen:
Evaluate the strategy :straight_ruler:
=> out-of-sample testing
Construction portfolio :house_buildings:
(1)
Risk models
:question:: considering
individual variance of positions and correlation across positions.
(2)
Trading cost
:money_with_wings:: explicit & implicit ( market impact cost)
Pitfalls
:warning:
Survivorship bias
Look-ahead bias (Results from using information in the model to give trading signals at a time when the information was not available.
datamining/ overfitting
Turnover
Lack of availability of stock to borrow
Transactions cost
Quant Overcrowding
MODULE 28.4 EQUITY INVESTMENT STYLE CLASSIFICATION
Returns-Based Analysis
:dark_sunglasses: 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
:check: 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
Holdings-Based Analysis
:microscope: looks at the attributes of each individual stock in a portfolio => to conclude the overall style of the portfolio :shirt: :jeans:
Morningstar Fund Style box
https://bit.ly/2U75PPQ
Allocatie by large/mid/small cap first
The style box approach aims to classify approximately the same number of stocks in each of the value, blend, and growth groups
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)
:check: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
:red_flag:
Stocks within a group: have a **high
correlation** with each other
correlation between groups
should be lower
indicating that styles are distinct sources of risk and return
:muscle: Strengths and :weary: Limitations of Style Analysis
https://bit.ly/36AX7vU
