R28 Active Equity Investing: Strategies

Question 1

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5 Types of Active Strategies

Answer 1

1. Factor Based
2. Activism
3. Statistical Arbitrage
4. Fundamental
5. Quantative

Question 2

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Fundamental Approach

Based on opinions

Answer 2

• Subjective in nature
• Discretion of analyst. Use financial statements etc.
• Human skill, experience, judgment
• Research (company/industry/economy)
• Conviction (high depth) in stock-, sector-, or region-based selection
• Forecast future corporate parameters and establish views on companies
• Use judgment and conviction within permissible risk parameters
• Likely to be fewer positions in portfolio, but allocate more to each position.
• Risk analyst is incorrect in his analysis
• Postions closely monitored by analyst and rebalanced based on their opinion

Question 3

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Quantative Approach

Based on models

Answer 3

• Objective. Relies on models to generate rules for selection of stocks.
• Systematic, non-discretionary
• Expertise in statistical modeling
• A selection of variables, subsequently applied broadly over a large number of securities
• Attempt to draw conclusions from a variety of historical data
• Use optimizers
• Quant managers will spread factor bets across many postions with smaller allocation
• Risk - of factors selected to not perform as predicated by the models.

Question 4

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Bottom Up Strategies General

Answer 4

• Starts with individual stocks / companies
• Value based and growth based strategies
• Value - finding companies trading below NAV
• Growth - identify conpanies that are expected to grow faster than the overall market

Question 5

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Bottom Up Strategies Value

Answer 5

1. Relative Value - compare price multiples (low P/E, P/S, P/B)
2. Contrarian Investing - contrarian managers invest in depressed cyclical stocks with low or even negative earnings or low dividend payments. Expect stocks to rebound once the company’s earnings have turned around
3. High-Quality Value - equal emphasis on financial strength and demonstrated profitability. Warren Buffett approach
4. Income Investing - Focus on shares with high dividend yields and postice growth in dividend.
5. Deep-Value Investing - extremely low valuation relative to their assets (e.g., low P/B). Increases chance of informational inefficiencies. Risk of falling into value trap (price continues to go down)
6. Restructuring and Distressed Investing - invest just prior to or after bankruptcy proceedings. J-Factor risk.
7. Special Situations - exploit mispricings from spin-offs, divestitures and mergers

Question 6

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Bottom Up Strategies Growth

Answer 6

1. Consistent Long Term Growth
2. Short Term Earnings Momentum
3. GARP - Use PEG ratio [calculated as the stock’s P/E divided by the expected earnings growth rate (in percentage terms)]. Often referred to as a hybrid of growth and value investing.

Question 7

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Top Down Strategies

Answer 7

• Macro Economic environment > industries > companies
• Often use EFT and derivatives to over / under weight market sectors

1. Country and Geographic Allocation to Equities - investing in different geographic regions depending on their assessment of the regions’ prospects.
2. Sector and Industry Rotation - a view on the expected returns of various sectors and industries across borders
3. Volatility-Based Strategies - view on volatility and is usually implemented using derivative instruments.
4. Thematic Investment Strategies - use broad macroeconomic, demographic, or political drivers

Question 8

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Factor Based Strategies

Answer 8

• Risk factor or style factor (i.e. variable or characteristics with which asset returns are generally correlated such as size, value, growth, price momentum, quality)
• Some factors (most commonly, size, value, momentum, and quality) have been shown to be positively associated with a long-term return premium and are often referred to as rewarded factors
• Unrewarded factors - not been empirically proven to offer a persistent return premium
• Factors used must make sense

Question 9

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Factor Based Strategies: Hedged Portfolio Approach

Answer 9

• Most traditional and widely used method for implementing factor-based portfolio.

Process

1. Choose the factor e.g. size
2. Ranking the investable stock universe by that factor e.g. by Market Cap
3. Divide the universe into groups referred to as quantiles to form quantile portfolios.
4. Stocks are either equally weighted or capitalization weighted within each quantile
5. Long/short hedged portfolio is typically formed by going long the best quantile and shorting the worst quantile
6. Performance of the hedged long/short portfolio is then tracked over time.

Question 10

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Factor Based Strategies: Hedge Portfolio Approach

Disadvantages

Answer 10

1. Middle quantiles is not utilized. Best performing companies may be in the middle.
2. Assumed the relationship between the factor and future stock returns is linear, which may not be the case
3. Portfolios built using this approach tend to be concentrated, and if many managers use similar factors, the resulting portfolios will be concentrated in specific stocks
4. The hedged portfolio requires managers to short stocks. Shorting may not be possible in some markets and may be overly expensive in others.
5. The hedged portfolio is not a “pure” factor portfolio because it has significant exposures to other risk factors.

Question 11

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Factor Based Strategies: Style Factors

Answer 11

1. Value - Value factors can also be based on other fundamental performance metrics of a company, such as dividends, earnings, cash flow, EBIT, EBITDA, and sales. Investors often add two more variations on most value factors by adjusting for industry (and/or country) and historical differences
2. Price Momentum - Researchers have also found a strong price momentum effect in almost all asset classes in most countries. Commonly attributed to behavioral biases, such as overreaction to information. Subject to extreme tail risk. To reduce downside risk removethe effect of sector exposure from momentum factor returns: sector-neutralized price momentum factor
3. Growth - Growth factors can also be classified as short-term growth (last quarter’s, last year’s, next quarter’s, or next year’s growth) and long-term growth (last five years’ or next five years’ growth)
4. Quality - using accounting ratios and share price data as fundamental style factors
5. Unconventional Factors Based on Unstructured Data - Using large data sets. Use of alternative or unstructured data such as satellite images, textual information, credit card payment information, and the number of online mentions of a particular product or brand.
6. Factor Timing - e.g. equity style rotation. Regression of factors against a specfic variable to decide the best style rotation.

Question 12

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Activist Strategies: Tactics

Answer 12

Tactics:

• Seeking board representation and nominations
• Engaging with management by writing letters to management calling for and explaining suggested changes, participating in management discussions with analysts or meeting the management team privately, or launching proxy contests whereby activists encourage other shareholders to use their proxy votes to effect change in the organization
• Proposing significant corporate changes during the annual general meeting (AGM)
• Proposing restructuring of the balance sheet to better utilize capital and potentially initiate share buybacks or increase dividends
• Reducing management compensation or realigning management compensation with share price performance
• Launching legal proceedings against existing management for breach of fiduciary duties
• Reaching out to other shareholders of the company to coordinate action
• Launching a media campaign against existing management practices
• Breaking up a large conglomerate to unlock value

Question 13

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Activist Strategies: Defenses

Answer 13

• Multi-class share structures whereby a company founder’s shares are typically entitled to multiple votes per share
• “Poison Pill” plans allowing the issuance of shares at a deep discount, which causes significant economic and voting dilution
• Staggered board provisions whereby a portion of the board members are not elected at annual shareholders meetings

Question 14

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Activist Strategies: 3 main Impacts

Answer 14

1. Lead to improvements in growth, profit and corporate governance
2. Forced companies to take on higher levels of debt
3. Activist funds have enjoyed Sharpe Ratios slightly above broad equity market

Question 15

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Strategies Based on Statistical Arbitrage and Market Microstructure

Answer 15

• Mean reversion
• Use statistical and technical analysis to exploit pricing anomalies

Tools used

1. Traditional technical analysis
2. Sophisticated time-series analysis and econometric models
3. Machine-learning techniques

Pairs trading is an example of a popular and simple statistical arbitrage strategy. Pairs trading uses statistical techniques to identify two securities that are historically highly correlated with each other. When the price relationship of these two securities deviates from its long-term average, managers that expect the deviation to be temporary go long the underperforming stock and simultaneously short the outperforming stock. If there is no mean reversion then there will be a loss. Use stop-loss.

Question 16

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7 steps of Fundamental Active Investment Process

Answer 16

1. Define the investment universe and the market opportunity—the perceived opportunity to earn a positive risk-adjusted return to active investing, net of costs—in accordance with the investment mandate. The market opportunity is also known as the investment thesis.
2. Prescreen the investment universe to obtain a manageable set of securities for further, more detailed analysis.
3. Understand the industry and business for this screened set by performing: industry and competitive analysis and analysis of financial reports.
4. Forecast company performance, most commonly in terms of cash flows or earnings.
5. Convert forecasts to valuations and identify ex ante profitable investments.
6. Construct a portfolio of these investments with the desired risk profile.
7. Rebalance the portfolio with buy and sell disciplines.

Question 17

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3 Pitfalls in Fundamental Investing

Answer 17

1. Behavioral biases
2. Value trap - Stock looks attractively priced but the stock price has not reached bottom.
3. Growth trap - The favourable prospects of stock are fully priced (or over priced) into stock. Further growth does not happen.

Question 18

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5 steps of Quantitative Investment Process

Answer 18

1. Defining the Market Opportunity (Investment Thesis)
2. Acquiring and Processing Data: Company mapping, Company fundamentals, Survey data, Unconventional data. Investors spend a significant amount of time checking data for consistency, cleaning up errors and outliers, and transforming the data into a usable format.
3. Back-testing the Strategy. Pearson IC (+1 to -1) - sensitive to outliers therefore Spearman Rank IC is preferred.
4. Evaluating the Strategy. Do an out-of-sample back-test, in which a different set of data is used to evaluate the model’s performance. Managers generally compute various statistics—such as the t-statistic, Sharpe ratio, Sortino ratio, VaR, conditional VaR, and drawdown characteristics—to form an opinion on the outcome of their out-of-sample back-test.
5. Portfolio Construction. Consideration of risk models and trading costs.

Question 19

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7 Pitfalls of quantitative active management

Answer 19

1. Survivorship Bias - leads to overly optimistic results and sometimes even causes investors to draw wrong conclusions.
2. Look-Ahead Bias - using information that was unknown or unavailable at the time an investment decision was made
3. Data Mining - excessive search analysis of past financial data to uncover patterns. Results in model overfitting
4. Turnover - may be limits on turnover
5. Transaction Costs - can easily erode returns significantly
6. Short Availability - difficulties in establishing short positions in certain markets
7. Quant Crowding - lots of managers following same strategy. If there is a period of poor performance and they may all need to exit positions at the same time - resulting in margin calls. This would cause even more unwinding of positions

Question 20

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Equity Investment Style Classification

Answer 20

• Whats is really the managers style.
• Examine the holdings and returns to determine style

Main methods:

1. Return based style analysis
2. Holdings based style analysis
3. Equity Style Box (subset of holding based)

Question 21

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Returns-Based Style Analysis

Answer 21

• Used find the style concentration of underlying holdings by identifying the style indexes that provide significant contributions to fund returns with the help of statistical tools.
• Indices should be mutually exclusive and exhaustive
• Key inputs are the historical returns for the portfolio and the returns for the style indexes
• Such an analysis attributes fund returns to selected investment styles by running a constrained multivariate regression
• 1-R² is how much of the regression is down to the managers stock selections capabilities (i.e. not explained by the market indices)
• A single factor model with have a low R² which might be misleading
• An inappropriate benchmark for the portfolio or fund may produce an inaccuate R²
• Helps determine the consistency of managers style. Limited if analysis is over one period.

Question 22

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Holdings Based Style Analysis

Answer 22

• Good for capturing style drift
• Looking at characteristics of stocks in the managers portfolio
• For accuracy need to analyse current portfolio holdings

Style Boxes

• Style score assigned to each individual stock in fund. The scores are scaled to a range of 0 to 100, and the difference between the stock’s growth and value scores is called the net style score.
• If this net style score is strongly negative, approaching –100, the stock’s style is classified as value. If the result is strongly positive, the stock is classified as growth. If the scores for value and growth are similar in strength, the net style score will be close to zero and the stock will be classified as core.

e.g. for Value factors, assign score 0-100 for P/E, P/B Dividend Yield etc. A security with a value score of 0.6 will have 60% of its market capitalization allocated to the value index and the remaining 40% to the growth index.

Question 23

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Strengths and Limitations of Style Analysis

Answer 23

• Holdings-based style analysis is generally more accurate than returns-based analysis because it uses the actual portfolio holdings
• Holdings-based style analysis requires the availability of all the portfolio constituents as well as the style attributes of each stock in the portfolio. While this information may be accessible for current portfolios, an analyst who wants to track the historical change in investment styles may face some difficulty.
• limited availability of data on derivatives often makes holdings-based style analysis less effective for funds with substantial positions in derivatives.
• Returns-based style analysis models impose unnecessary constraints that limit the results within certain boundaries, making it difficult to detect more aggressive positions, such as deep value or micro cap.
• Ideally, use both approaches: Returns-based models can often be more widely applied, while holdings-based models allow deeper style analysis.