Reading 24: Active Equity Investing: Strategies Flashcards
Fundamental Vs Quantitative Managers
It is how the final investment decision is made that determines whether the manager is classified as quantitative or fundamental. If the decision is made based on systematic rules rigidly applied to company data, then the manager would be classified as quantitative. If the investment decision is made based on the manager’s opinion using their skill and experience, then the manager is deemed to be fundamental. Screening for low P/B ratios can be used for both initially. Fundamental will have less holdings than quantitative (due to research intensity) and will be monitored more closely. Fundamental uses discretion, where quantitative is objective. Quantitative is rebalanced at specific intervals, fundamental is monitored continuously. Quantitative risk lies at the portfolio level, fundamental at the security level. The quantitative decision-making process is systematic and non-discretionary.
Activist Investors
Do not take controlling interest (more than 50%), but take a significant but minority interest of less than 10% to garner support from other shareholders. Activists typically have a shorter horizon than a buy and hold investor. Target companies have slower earnings and revenue growth, negative share price momentum, weak corporate governance, large cash on hand. Activism leads to improvements in growth and positive price movements leading up to activism but higher debt levels.
Paris Trade
Only used if fundamental reasons are the cause for the breakdown in correlation between the company and its competitor. Even if the company’s have high correlation in stock price movements, if they are not similar businesses the correlation is likely spurious and won’t persist into the future. 2 SD from moving average indicates action to be taken.
Reasonable Priced Growth
Investor will choose the portfolio with the lowest PEG ratio (P/E over growth as percentage).
Returns Based Analysis
The intercept term is interpreted as the value added by the manager.
Information Coefficient
The cross-sectional correlation between a factor score and the subsequent stock return. If it is high the factor has predictive power.
Statistical Arbitrage
Use statistical and technical analysis to exploit pricing anomalies. These strategies rely on extensive use of data and are typically implemented in a systematic, rules-based way. Paris trading refers to mean reversion of two securities with high correlation, buy underperforming strategy and short over performing. When the spread is high it generates a sell signal and a buy signal when it’s low relative to its moving average.
Value Trap
Usually more common in fundamental investing. A quantitative process that relies on historical information and does not integrate future expectations about cash flows or profitability may be unable to detect a value trap
Back Testing
The purpose of back-testing is to identify correlations between the current period’s factor scores, and the next period’s holding period strategy returns. The correlation coefficients are called the information coefficient (IC).
Bottom Up
Includes value-based & growth-based. Value includes relative value, contrarian investing, high-quality value (intrinsic value and financial strength), income investing, deep-value investing (often due to financial distress), restructuring investing (investing prior to or during expected bankruptcy filing), special situations (mergers or spin offs etc). Growth based focuses on consistent earnings growth, shorter term earnings momentum, GARP (growth at reasonable price, low PEG ratio).
Top Down
Typically use ETFs and derivatives. Focus on following dimensions: country/geography, industry sector, volatility, thematic investment strategies (new tech, economic cycles, regulation changes).
The Hedged Portfolio Approach
Rank investable stock universe by the factor, divide the universe into quantiles, form long/short portfolio by going long the best quantile and shorting the worst. Info in middle quantiles is lost, assumes linear relationship between factor and stock returns, can appear diversified but factors may be correlated.
Factor Mimicking Portfolio
A dollar neutral theoretical long/short portfolio with a one for one (unit) exposure to a chosen factor and exposure of zero to other factors. Spread across broad array of stocks. Managers can experience liquidity and short selling constraints.
Market Microstructure-Based
Take advantage of mispricing opportunities occurring due to supply/demand imbalances that last for a few milliseconds.
Event Driven Arbitrage Strategies
Risk arbitrage is associated with M&A activity. In a cash merger the manager will buy shares of target, profiting when the deal closes (as price will be below close price due to risk). In a share-for-share transaction the manager will short shares of the acquirer and buy shares of target at conversion ratio.
Information Coefficients
Pearson IC is sensitive to even a few outliers, where as Spearman is not and is favoured. The Spearman Rank information coefficient is more robust to the nonlinear relationship because it is only measuring the correlation between rankings and not the raw data. The information coefficient is calculated as the correlation between the factor score of a security and the subsequent return of the security. If the information coefficient is high this implies the factor has predictive power.
Style Classification: Holdings-Based Style Analysis
Looks at attributes of individual securities. Morningstar style box splits securities into three groups (value, growth and bench/core). Classification is based on scores (0 being low score and 100 being high). If the net style score is close to zero the stock will be classified as core (neither positive nor negative in rating). Securities can exhibit both value and growth and can be classified different ways with different definitions. Requires availability of all constituents but is accurate.
Style Classification: Returns-Based Style Analysis
Aims to identify the style of the fund through a regression analyses of funds returns against a set of passive style indices. If the coefficient is significant the portfolio has exposure to that factor. Doesn’t require info on holdings and can be easily and universally applied.
Equity Style Rotation Strategy
An equity-style rotation strategy can be used by both quantitative and fundamental investors, although it is more common in quantitative investing.
Hedged Portfolio
The hedged portfolio is not a pure factor portfolio because it typically has significant exposures to other risk factors. The hedged portfolio approach implicitly assumes a linear relationship between the factor and stock returns. Any nonlinear relationship between the factors and stock returns will not be captured by this approach. Because the hedged portfolio approach uses information from the top and bottom quantiles of the investable stock universe for the factor, information in the middle quantiles will be ignored.
Strategies
Relative value, look for lower P/E don’t worry about growth. GARP look for similar P/E and growth rates that are high.
