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LM5 Active Equity Investing: Strategies 2024 Level III Notes © IFT. All rights reserved 1 LM5 Active Equity Investing: Strategies 1. Introduction .......................................................................................................................................................2 2. Approaches to Active Management...........................................................................................................2 Differences in the Nature of the Information Used............................................................................3 Differences in the Focus of the Analysis.................................................................................................4 Difference in Orientation to the Data: .....................................................................................................4 Differences in Portfolio Construction: Judgment vs. Optimization..............................................5 3. Bottom-Up Strategies......................................................................................................................................6 4. Top- Down Strategies .................................................................................................................................. 10 5,6&7: Factor-Based Strategies .................................................................................................................... 11 8. Activist Strategies.......................................................................................................................................... 16 9. Other Active Strategies................................................................................................................................ 18 Strategies Based on Statistical Arbitrage and Market Microstructure.................................... 18 Event-Driven Strategies............................................................................................................................. 20 10. Creating a Fundamental Active Investment Strategy................................................................... 21 The Fundamental Active Investment Process................................................................................... 21 Pitfalls in Fundamental Investing .......................................................................................................... 22 11. Creating a Quantitative Active Investment Strategy..................................................................... 24 Creating a Quantitative Investment Process ..................................................................................... 24 Pitfalls in Quantitative Investment Processes................................................................................... 26 12. Equity Investment Style Classification............................................................................................... 27 Different Approaches to Style Classification...................................................................................... 28 Strengths and Limitations of Style Analysis....................................................................................... 29 Summary ............................................................................................................................................................... 31 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM5 Active Equity Investing: Strategies 2024 Level III Notes © IFT. All rights reserved 2 1. Introduction This reading gives a broad overview of active equity investing. Section 2 discusses the two main approaches to active management – the fundamental and quantitative approaches. Sections 3 to 9 discuss bottom-up, top-down, factor-based, and activist investing strategies. Section 10 describes how to create fundamental active investment strategies. Section 11 describes the process of creating quantitative active investment strategies. Finally, Section 12 discusses style classifications of active strategies and uses/limitations of such classifications. 2. Approaches to Active Management The two main approaches to active management are ‘fundamental’ and ‘quantitative’. Fundamental approaches are based on analyzing the fundamentals of a company such as – cash flows, earnings, and revenue. Different aspects of a company are forecasted to determine if it is currently undervalued or overvalued. For example: Consider an auto analyst who is evaluating five of the largest auto companies. He carefully studies the past financial statements of these companies and prepares forecasted financial statements. He also evaluates their corporate governance and management quality. Based on this analysis he determines the intrinsic values of these companies and compares them with the current market values to reach a buy/sell decision. Quantitative approaches, on the other hand, rely heavily on computer programs and analyzing substantial amounts of data. A pattern or relationship between a given set of variables and security prices is established. A portfolio is then constructed by selecting securities with the desired exposure to the chosen set of variables. For example, consider a universe of 5,000 stocks. An analyst believes that companies with consistent dividends, P/B ratio less than 2, and earnings trending up over the last 12 quarters are likely to perform well. With the help of computer programs, the analyst will identify companies that meet these criteria and create a portfolio of selected companies. The two approaches are not necessarily mutually exclusive. Fundamental approaches may involve the use of computer programs to analyze financial statements, predict financial statements, etc. Quantitative approaches may use variables that relate to company fundamentals. Quantitative analysis can be used to identify a small subset of stocks and fundamental approaches can then be applied to these stocks. Exhibit 1 of the curriculum summarizes the typical differences between fundamental and quantitative approaches. Fundamental Quantitative Style Subjective Objective
LM5 Active Equity Investing: Strategies 2024 Level III Notes © IFT. All rights reserved 3 Decision- making process Discretionary Systematic, non- discretionary Primary resources Human skill, experience, judgment Expertise in statistical modeling Information used Research (company/industry/economy) Data and statistics Analysis focus Conviction (high depth) in stock-, sector-, or region- based selection A selection of variables, subsequently applied broadly over a large number of securities Orientation to data Forecast future corporate parameters and establish views on companies Attempt to draw conclusions from a variety of historical data Portfolio construction Use judgment and conviction within permissible risk parameters Use optimizers These differences are discussed in detail in the following sections. Differences in the Nature of the Information Used Fundamental Quantitative Relies heavily on research data. Bottom-up fundamental analysts use company data. They identify companies that are likely to perform well. A portfolio is created using these companies. Top-down fundamental analysts start first with region, country, or sector information and then narrow down to companies. Not all data can be quantified. For example, corporate governance, quality of company management, ESG considerations, etc. are important factors used in the analysis but are not easily quantifiable. A significant amount of judgment is required in the fundamental analysis as it involves making predictions about future performance. Relies heavily on data and statistics. Analysts use historical data. The focus is on quantitative information. Non-quantitative information, such as corporate governance, management quality, etc. is usually not given much importance. Judgment is used in model building, for example – what screening criteria to use and in which order. Once a model is finalized, computer programs are used to process data in a systematic way rather than a judgmental way. Analysts need to avoid survivorship and look ahead biases.
LM5 Active Equity Investing: Strategies 2024 Level III Notes © IFT. All rights reserved 4 Differences in the Focus of the Analysis Fundamental Quantitative Analysts have conviction in stock-, sector-, or region-based selection. Here the focus is on a small group of stocks. An in-depth analysis is performed on these stocks. Analysts focus on a selection of variables that are subsequently applied broadly over a large number of securities. Here the focus is on factors across a large group of stocks. Relatively large positions are taken in selected stocks. Analysts have conviction in the selection criteria, and not in any particular stock. Therefore, relatively smaller positions are taken across many stocks that meet the criteria. Difference in Orientation to the Data: Forecasting Fundamentals vs. Pattern Recognition Fundamental Quantitative Analysts forecast future corporate parameters to establish a view on companies. For example, revenues, earnings, and cash flows can be forecasted to determine the intrinsic value of a company. Analysts also identify catalysts that generate future growth. Analysts attempt to draw conclusions from a variety of historical data. A typical strategy is to construct models by back-testing past data. Back-testing: Consider a simple example to understand how back-testing works. An analyst believes that stocks with a P/B < 2 will perform well. To back-test, the analyst can apply this selection criterion at any point of time in the past, for example, end of 2010. Using the data that was available at the end of 2010, stocks with P/B < 2 can be selected. Consequently, an analyst can then determine whether these stocks outperformed the market on a risk adjusted basis in the upcoming year i.e., 2011. A similar exercise can be conducted for other periods and other selection criteria to evaluate which criteria are most likely to give superior returns. An implicit assumption made here is that criteria that worked well in the past will continue to work in the future. While performing back testing an analyst should avoid look-ahead bias. Only information that would have been available at the chosen time period should be used in the analysis. Information that was available later should not be considered.