Refresher Reading
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2021 Curriculum CFA Program Level III Portfolio Management and Wealth Planning
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This reading provides an overview of active equity investing and the major types of active equity strategies. The reading is organized around a classification of active equity strategies into two broad approaches: fundamental and quantitative. Both approaches aim at outperforming a passive benchmark (for example, a broad equity market index), but they tend to make investment decisions differently. Fundamental approaches stress the use of human judgment in processing information and making investment decisions, whereas quantitative approaches tend to rely more heavily on rules-based quantitative models. As a result, some practitioners and academics refer to the fundamental, judgment-based approaches as “discretionary” and to the rules-based, quantitative approaches as “systematic.”
This reading is organized as follows. Section 2 introduces fundamental and quantitative approaches to active management. Section 3 discusses bottom-up, top-down, factor-based, and activist investing strategies. Section 4 describes the process of creating fundamental active investment strategies, including the parameters to consider as well as some of the pitfalls. Section 5 describes the steps required to create quantitative active investment strategies, as well as the pitfalls in a quantitative investment process. Section 6 discusses style classifications of active strategies and the uses and limitations of such classifications. A summary of key points completes the reading.
Learning Outcomes
The member should be able to:
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compare fundamental and quantitative approaches to active management;
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analyze bottom-up active strategies, including their rationale and associated processes;
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analyze top-down active strategies, including their rationale and associated processes;
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analyze factor-based active strategies, including their rationale and associated processes;
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analyze activist strategies, including their rationale and associated processes;
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describe active strategies based on statistical arbitrage and market microstructure;
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describe how fundamental active investment strategies are created;
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describe how quantitative active investment strategies are created;
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discuss equity investment style classifications.
Summary
This reading discusses the different approaches to active equity management and describes how the various strategies are created. It also addresses the style classification of active approaches.
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Active equity management approaches can be generally divided into two groups: fundamental (also referred to as discretionary) and quantitative (also known as systematic or rules-based). Fundamental approaches stress the use of human judgment in arriving at an investment decision, whereas quantitative approaches stress the use of rules-based, quantitative models to arrive at a decision.
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The main differences between fundamental and quantitative approaches include the following characteristics: approach to the decision-making process (subjective versus objective); forecast focus (stock returns versus factor returns); information used (research versus data); focus of the analysis (depth versus breadth); orientation to the data (forward looking versus backward looking); and approach to portfolio risk (emphasis on judgment versus emphasis on optimization techniques).
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The main types of active management strategies include bottom-up, top-down, factor-based, and activist.
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Bottom-up strategies begin at the company level, and use company and industry analyses to assess the intrinsic value of the company and determine whether the stock is undervalued or overvalued relative to its market price.
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Fundamental managers often focus on one or more of the following company and industry characteristics: business model and branding, competitive advantages, and management and corporate governance.
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Bottom-up strategies are often divided into value-based approaches and growth-based approaches.
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Top-down strategies focus on the macroeconomic environment, demographic trends, and government policies to arrive at investment decisions.
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Top-down strategies are used in several investment decision processes, including the following: country and geographic allocation, sector and industry rotation, equity style rotation, volatility-based strategies, and thematic investment strategies.
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Quantitative equity investment strategies often use factor-based models. A factor-based strategy aims to identify significant factors that drive stock prices and to construct a portfolio with a positive bias towards such factors.
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Factors can be grouped based on fundamental characteristics—such as value, growth, and price momentum—or on unconventional data.
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Activist investors specialize in taking meaningful stakes in listed companies and influencing those companies to make changes to their management, strategy, or capital structures for the purpose of increasing the stock’s value and realizing a gain on their investment.
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Statistical arbitrage (or “stat arb”) strategies use statistical and technical analysis to exploit pricing anomalies and achieve superior returns. Pairs trading is an example of a popular and simple statistical arbitrage strategy.
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Event-driven strategies exploit market inefficiencies that may occur around corporate events such as mergers and acquisitions, earnings announcements, bankruptcies, share buybacks, special dividends, and spinoffs.
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The fundamental active investment process includes the following steps: define the investment universe; prescreen the universe; understand the industry and business; forecast the company’s financial performance; convert forecasts into a target price; construct the portfolio with the desired risk profile; and rebalance the portfolio according to a buy and sell discipline.
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Pitfalls in fundamental investing include behavioral biases, the value trap, and the growth trap.
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Behavioral biases can be divided into two groups: cognitive errors and emotional biases. Typical biases that are relevant to active equity management include confirmation bias, illusion of control, availability bias, loss aversion, overconfidence, and regret aversion.
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The quantitative active investment process includes the following steps: define the investment thesis; acquire, clean, and process the data; backtest the strategy; evaluate the strategy; and construct an efficient portfolio using risk and trading cost models.
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The pitfalls in quantitative investing include look-ahead and survivorship biases, overfitting, data mining, unrealistic turnover assumptions, transaction costs, and short availability.
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An investment style generally splits the stock universe into two or three groups, such that each group contains stocks with similar characteristics. The common style characteristics used in active management include value, size, price momentum, volatility, high dividend, and earnings quality. A stock’s membership in an industry, sector, or country group is also used to classify the investment style.
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Two main approaches are often used in style analysis: a returns-based approach and a holdings-based approach. Holdings-based approaches aggregate the style scores of individual holdings, while returns-based approaches analyze the investment style of portfolio managers by comparing the returns of the strategy to those of a set of style indexes.
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Categories
Active Management
Equity Investments
