Active Equity Investing (Practice Questions)
James Leonard is a fund-of-funds manager with Future Generation, a large sovereign fund. He is considering whether to pursue more in-depth due diligence processes with three large-cap long-only funds proposed by his analysts. Although the funds emphasize different financial metrics and use different implementation methodologies, they operate in the same market segment and are evaluated against the same benchmark. The analysts prepared a short description of each fund, presented in Exhibit 1.
Exhibit 1:
Description of Each Candidate Fund
Fund
Description
Furlings
Furlings Investment Partners combines sector views and security selection. The firm’s head manager uses several industry and economic indicators identified from his own experience during the last two decades, as well as his personal views on market flow dynamics, to determine how to position the fund on a sector basis. Sector deviations from the benchmark of 10% or more are common and are usually maintained for 12 to 24 months. At the same time, sector managers at Furlings use their expertise in dissecting financial statements and their understanding of the corporate branding and competitive landscape within sectors to build equally weighted baskets of securities within sectors. Each basket contains their 7 to 10 highest-conviction securities, favoring firms that have good governance, strong growth potential, competitive advantages such as branding, and attractive relative valuations. The Furlings master fund holds approximately 90 securities.
Asgard
Asgard Investment Partners is a very large asset manager. It believes in investing in firms that have a strong business model and governance, reasonable valuations, solid capital structures with limited financial leverage, and above-average expected earnings growth for the next three years. Although the Asgard master fund invests in fewer than 125 securities, each sector analyst builds financial models that track as many as 50 firms. To support them in their task, analysts benefit from software developed by the Asgard research and technology group that provides access to detailed market and accounting information on 5,000 global firms, allowing for the calculation of many valuation and growth metrics and precise modeling of sources of cash-flow strengths and weaknesses within each business. Asgard analysts can also use the application to back-test strategies and build their own models to rank securities’ attractiveness according to their preferred characteristics. Security allocation is determined by a management team but depends heavily on a quantitative risk model developed by Asgard. Asgard has a low portfolio turnover.
Tokra
Tokra Capital uses a factor-based strategy to rank securities from most attractive to least attractive. Each security is scored based on three metrics: price to book value (P/B), 12-month increase in stock price, and return on assets. Tokra’s managers have a strong risk management background. Their objective is to maximize their exposure to the most attractive securities using a total scoring approach subject to limiting single-security concentration below 2%, sector deviations below 3%, active risk below 4%, and annual turnover less than 40%, while having a market beta close to 1. The master fund holds approximately 400 positions out of a possible universe of more than 2,000 securities evaluated.
When Leonard’s analysts met with Asgard, they inquired whether its managers engage in activist investing because Asgard’s portfolio frequently holds significant positions, because of their large asset size, and because of their emphasis on strong governance and their ability to model sources of cash-flow strengths and weaknesses within each business. The manager indicated that Asgard engages with companies from a long-term shareholder’s perspective, which is consistent with the firm’s low portfolio turnover, and uses its voice, and its vote, on matters that can influence companies’ long-term value.
Leonard wants to confirm that each manager’s portfolios are consistent with its declared style. To this end, Exhibit 2 presents key financial information associated with each manager’s portfolio and also with the index that all three managers use.
Exhibit 2:
Key Financial Data
Fund
Index
Furlings
Asgard
Tokra
Dividend/price (trailing 12-month)
2.3%
2.2%
2.2%
2.6%
P/E (trailing 12-month)
26.5
24.7
26.6
27.3
Price/cash flows (12-month forward)
12.5
13.8
12.5
11.6
P/B
4.8
4.30
4.35
5.4
Average EPS growth (three to five years forward)
11.9%
11.0%
13.1%
10.8%
Net income/assets
2.8%
4.5%
4.3%
3.2%
Average price momentum (trailing 12 months)
10.5%
14.0%
10.0%
12.0%
Q.
Which fund manager’s investing approach is most consistent with fundamental management?
Q.
Which of the following statements about the approaches and styles of either Furlings, Asgard, or Tokra is incorrect?
Solution
C is an incorrect statement. Although Tokra is a factor manager, and although it uses a value proxy such as P/B and a profitability proxy such as return on assets, it does not use a growth proxy such as earnings growth over the last 12 or 36 months but rather a price momentum proxy.
A is a correct statement. Furlings is a top-down manager. It makes significant sector bets based on industry and economic indicators derived from the head manager’s experience, and it does select its securities within sectors while considering relative valuation.
B is a correct statement. Asgard favors securities that have reasonable valuations and above-average growth prospects. It has a bottom-up approach and builds its portfolio starting at the security level.
Q.
Which manager is most likely to get caught in a value trap?
A.Furlings
B.Asgard
C.Tokra
Solution
C is the correct answer. A value trap occurs when a stock that appears to have an attractive valuation because of a low P/E and/or P/B multiple (or other relevant value proxies) appears cheap only because of its worsening growth prospects. Although a pitfall such as value trap is 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.
A is an incorrect answer. Although Furlings is a top-down manager, its sector portfolios are built through investing in a small number of high-conviction securities after its analysts have dissected the financial statements and analyzed the competitive landscape and growth prospects. Managers at Furlings are more likely than managers at Tokra to be aware of the significant deteriorating prospects of a security they are considering for investment.
B is an incorrect answer. One of Asgard’s investment criteria is identifying firms that have good potential cash flow growth over the next three years. The firm has access to database and support tools, allowing its analysts to evaluate many potential growth metrics. Managers at Asgard are more likely than managers at Tokra to be aware of the significant deteriorating prospects of a security they are considering for investment.
Q.
Which activist investing tactic is Asgard least likely to use?
A.Engaging with management by writing letters to management, calling for and explaining suggested changes, and participating in management discussions with analysts or meeting the management team privately
B.Launching legal proceedings against existing management for breach of fiduciary duties
C.Proposing restructuring of the balance sheet to better utilize capital and potentially initiate share buybacks or increase dividends
Solution
B is the correct answer. Asgard invests in firms that have strong business models and good governance. Also, it approaches investing as a long-term investor looking to use its voice to improve the company’s asset management. Asgard is unlikely to use an aggressive posturing or to invest or stay invested in companies with weak governance or where managers may be in breach of fiduciary duties.
A is an incorrect answer. Engaging in positive conversations with management of companies with which Asgard has invested reflects a use of its voice to improve these companies’ long-term value.
C is an incorrect answer. Because Asgard is strong at modeling sources of cash flows and is known for investing in companies with a strong capital structure, it would be consistent for Asgard to propose ways to optimize the capital structure and shareholders’ compensation.
Q.
Based on the information provided in Exhibits 1 and 2, which manager’s portfolio characteristics is most likely at odds with its declared style?
A.Furlings
B.Asgard
C.Tokra
Solution
C is the correct answer. Tokra indicates that it emphasizes three metrics: P/B, 12-month price momentum, and return on assets. Although the portfolio consists of securities that have stronger momentum than those of the index on average, and although the ratio of net income to assets is also favorable, the average P/B is somehow higher than that of the index. Although this scenario could normally be explained by an emphasis on specific sectors with a higher P/B than other sectors, the low level of sector deviation tolerated within the strategy weakens that explanation. This should be explored with Tokra’s managers.
A is an incorrect answer. Furlings is a top-down sector rotator with a value orientation within sectors. The lower P/B and P/E and higher net income over assets are consistent with a relative value orientation. Because Furlings can take significant positions in specific sectors, however, there could be other circumstances in which the portfolio would have a higher P/B and/or P/E and or a lower net income /assets than the index if the fund were to emphasize sectors having such characteristics. Yet, this would not necessarily imply that the firm does not favor the most attractive relative valuations within sectors.
B is an incorrect answer. Asgard invests in firms that offer reasonable valuations and above-average expected cash flow growth during the next three years. The data, such as P/B and average expected three-year profit growth, are consistent with its declared style. Again, it is not necessarily inconsistent to emphasize these aspects while investing in a portfolio that has a lower dividend yield, slightly higher P/E, and lower price momentum.
Solution
C is a correct answer. Morningstar calculates a score for value and growth on a scale of 0 to 100 using five proxy measures for each. The value score is subtracted from the growth score. A strongly positive net score leads to a growth classification, and a strongly negative score leads to a value classification. A score relatively close to zero indicates a core classification. To achieve a blend classification, the portfolio must have a balanced exposure to stocks classified as value and growth, a dominant exposure to stocks classified as core, or a combination of both.
A is an incorrect answer. Both Morningstar and Lipper classify individual stocks in a specific style category. Neither assumes a security can belong to several styles in specific proportion.
B is an incorrect answer. The Lipper methodology does have a core classification. It sums the Z-score of six portfolio characteristics over several years to determine an overall Z-score that determines either a value, core, or growth classification.
Jack Dewey is managing partner of DC&H, an investment management firm, and Supriya Sardar is an equity analyst with the firm. Dewey recently took over management of the firm’s Purity Fund. He is developing a fundamental active investment process for managing this fund that emphasizes financial strength and demonstrated profitability of portfolio companies. At his previous employer, Dewey managed a fund for which his investment process involved taking active exposures in sectors based on the macroeconomic environment and demographic trends.
Dewey and Sardar meet to discuss developing a fundamental active investment process for the Purity Fund. They start by defining the investment universe and market opportunity for the fund, and then they pre-screen the universe to obtain a manageable set of securities for further, more detailed analysis. Next, Dewey notes that industry and competitive analysis of the list of securities must be performed. He then asks Sardar to recommend the next step in development of the fundamental active management process.
During the next few months, Dewey rebalances the Purity Fund to reflect his fundamental active investment process. Dewey and Sardar meet again to discuss potential new investment opportunities for the fund. Sardar recommends the purchase of AZ Industrial, which she believes is trading below its intrinsic value, despite its high price-to-book value (P/B) relative to the industry average.
Dewey asks Sardar to perform a bottom-up style analysis of the Purity Fund based on the aggregation of attributes from individual stocks in the portfolio. Dewey plans to include the results of this style analysis in a profile he is preparing for the fund.
QuestionQ.
In managing the fund at his previous employer, Dewey’s investment process can be best described as:
A.an activist strategy.
B.a top-down strategy.
C.a bottom-up strategy.
Solution
B is correct. At his previous firm, Dewey managed a fund for which his investment process involved taking active exposures in sectors based on the macroeconomic environment and demographic trends. An investment process that begins at a top, or macro level, is a top-down strategy. Top-down portfolio strategies study variables affecting many companies or whole sectors, such as the macroeconomic environment, demographic trends, and government policies. This approach differs from bottom-up strategies, which focus on individual company variables in making investment decisions. It also differs from activist strategies, which take stakes in listed companies and advocate changes for the purpose of producing a gain on the investment.2
Q.
Sardar’s recommendation for the next step should be to:
Solution
C is correct. The steps to developing a fundamental active investment process are as follows:
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.
Prescreen the investment universe to obtain a manageable set of securities for further, more detailed analysis.
Understand the industry and business for this screened set by performing industry and competitive analysis and analyzing financial reports.
Forecast company performance, most commonly in terms of cash flows or earnings.
Convert forecasts to valuations and identify ex ante profitable investments.
Construct a portfolio of these investments with the desired risk profile.
Rebalance the portfolio with buy and sell disciplines.
So, Sardar should recommend that the next step in the development of the fundamental active management process be forecasting companies’ performances and converting those forecasts into valuations.
Q.
Based upon Dewey’s chosen investment process for the management of the Purity Fund, rebalancing of the fund will most likely occur:
A.at regular intervals.
B.in response to changes in company-specific information.
C.in response to updated output from optimization models.
Solution
B is correct. Managers using an active fundamental investment process, like Dewey’s, usually monitor the portfolio’s holdings continuously and may rebalance at any time. In contrast, portfolios using a quantitative approach are usually rebalanced at regular intervals, such as monthly or quarterly, or in response to updated output from optimization models. A is incorrect because portfolios using a quantitative (not fundamental) active approach are usually rebalanced at regular intervals, such as monthly or quarterly. C is incorrect because construction of a quantitative portfolio (not a fundamental portfolio) typically involves using a portfolio optimizer, which controls for risk at the portfolio level in arriving at individual stock weights and leads to rebalancing decisions.
Q.
Which investment approach is the most likely basis for Sardar’s buy recommendation for AZ Industrial?
A.Relative value
B.High-quality value
C.Deep-value investing
Solution
B is correct. Dewey has developed a fundamental active investment process for the Purity Fund that emphasizes financial strength and demonstrated profitability. High-quality value investors focus on companies’ intrinsic values that are supported by attractive valuation metrics, with an emphasis on financial strength and demonstrated profitability. In their view, investors sometimes behave irrationally, making stocks trade at prices very different from intrinsic value based on company fundamentals. A is incorrect because investors who pursue a relative value strategy evaluate companies by comparing their value indicators (e.g., P/E or P/B multiples) with the average valuation of companies in the same industry sector, in an effort to identify stocks that offer value relative to their sector peers. AZ Industrial is trading at a high P/B relative to the industry average, which is contrary to relative value and suggests that the relative value approach was not the basis for Sardar’s buy recommendation. C is incorrect because a deep-value investing approach focuses on undervalued companies that are available at extremely low valuation relative to their assets. Such companies are often those in financial distress, which is not reflective of financial strength or demonstrated profitability. Therefore, Sardar’s buy recommendation was not based on a deep-value investing orientation.
Q.
The analysis performed by Sardar on the Purity Fund can be best described as being based on:
Solution
A is correct. Dewey asks Sardar to perform a bottom-up style analysis of the Purity Fund based on the aggregation of attributes from individual stocks in the portfolio, which describes a holdings-based approach to style analysis. The overall equity investment style is an aggregation of attributes from individual stocks in the portfolio, weighted by their positions.
Aleksy Nowacki is a new portfolio manager at Heydon Investments. The firm currently offers a single equity fund, which uses a top-down investment strategy based on fundamentals. Vicky Knight, a junior analyst at Heydon, assists with managing the fund.
Nowacki has been hired to start a second fund, the Heydon Quant Fund, which will use quantitative active equity strategies. Nowacki and Knight meet to discuss distinct characteristics of the quantitative approach to active management, and Knight suggests three such characteristics:
Characteristic 1
The focus is on factors across a potentially large group of stocks.
Characteristic 2
The decision-making process is systematic and non-discretionary.
Characteristic 3
The approach places an emphasis on forecasting the future prospects of underlying companies.
Nowacki states that quantitative investing generally follows a structured and well-defined process. Knight asks Nowacki:
“What is the starting point for the quantitative investment process?”
The new Heydon Quant Fund will use a factor-based strategy. Nowacki assembles a large dataset with monthly standardized scores and monthly returns for the strategy to back-test a new investment strategy and calculates the information coefficient. FS(t) is the factor score for the current month, and FS(t + 1) is the score for the next month. SR(t) is the strategy’s holding period return for the current month, and SR(t + 1) is the strategy’s holding period return for the next month.
As an additional step in back-testing of the strategy, Nowacki computes historical price/book ratios (P/Bs) and price/earnings ratios (P/Es) using calendar year-end (31 December) stock prices and companies’ financial statement data for the same calendar year. He notes that the financial statement data for a given calendar year are not typically published until weeks after the end of that year.
Because the Heydon Quant Fund occasionally performs pairs trading using statistical arbitrage, Nowacki creates three examples of pairs trading candidates, presented in Exhibit 1. Nowacki asks Knight to recommend a suitable pair trade.
Exhibit 1:
Possible Pairs Trades Based on Statistical Arbitrage
Stock Pair
Current Price Ratio Compared with Long-Term Average
Historical Price Ratio Relationship
Historical Correlation between Returns
1 and 2
Not significantly different
Mean reverting
High
3 and 4
Significantly different
Mean reverting
High
5 and 6
Significantly different
Not mean reverting
Low
Knight foresees a possible scenario in which the investment universe for the Heydon Quant Fund is unchanged but a new factor is added to its multifactor model. Knight asks Nowacki whether this scenario could affect the fund’s investment-style classifications using either the returns-based or holdings-based approaches.
Q.
Which of the following asset allocation methods would not likely be used by Nowacki and Knight to select investments for the existing equity fund?
A.Sector and industry rotation
B.Growth at a reasonable price
C.Country and geographic allocation
Solution
B is correct. The firm currently offers a single equity fund, which uses a top-down investment strategy. Country and geographic allocation and sector and industry rotation are both top-down strategies that begin at the top or macro level and are consistent with the fund’s top-down investment strategy. Growth at a reasonable price (GARP), however—a growth-based approach—is a bottom-up asset selection strategy that begins with data at the company level. Therefore, Nowacki and Knight likely would not use the GARP approach to select investments for the existing equity fund, which uses a top-down investment strategy. A is incorrect because sector and industry rotation is a top-down strategy, consistent with the fund’s top-down approach. C is incorrect because country and geography selection is a top-down strategy, consistent with the fund’s top-down approach.
Q.
Which of the following asset allocation methods would not likely be used by Nowacki and Knight to select investments for the existing equity fund?
Solution
B is correct. The firm currently offers a single equity fund, which uses a top-down investment strategy. Country and geographic allocation and sector and industry rotation are both top-down strategies that begin at the top or macro level and are consistent with the fund’s top-down investment strategy. Growth at a reasonable price (GARP), however—a growth-based approach—is a bottom-up asset selection strategy that begins with data at the company level. Therefore, Nowacki and Knight likely would not use the GARP approach to select investments for the existing equity fund, which uses a top-down investment strategy. A is incorrect because sector and industry rotation is a top-down strategy, consistent with the fund’s top-down approach. C is incorrect because country and geography selection is a top-down strategy, consistent with the fund’s top-down approach.
Q.
Relative to Heydon’s existing fund, the new fund will most likely:
Solution
B is correct. Portfolios managed using a quantitative approach are usually rebalanced at regular intervals, such as monthly or quarterly. In contrast, portfolios managed using a fundamental approach usually monitor the portfolio’s holdings continuously and may increase, decrease, or eliminate positions at any time.
Also, the focus of a quantitative approach is on factors across a potentially large group of stocks, whereas fundamental strategies focus on a relatively small group of stocks. Consequently, Heydon’s new quantitative fund will likely hold a larger number of stocks than the existing equity fund.
Finally, managers following a fundamental approach typically select stocks by performing extensive research on individual companies; thus, fundamental investors see risk at the company level. In contrast, with a quantitative approach, the risk is that factor returns will not perform as expected. Because the quantitative approach invests in baskets of stocks, the risks lie at the portfolio level rather than at the level of specific stocks (company level). Consequently, Nowacki’s new quantitative fund will likely see risk at the portfolio level, rather than the company level as the existing equity fund does.
Q.
Which characteristic suggested by Knight to describe the quantitative approach to active management is incorrect?
A.Characteristic 1
B.Characteristic 2
C.Characteristic 3
Solution
C is correct. Quantitative analysis uses a company’s history to arrive at investment decisions. The quantitative decision-making process is systematic and non-discretionary (whereas the fundamental decision-making process is more discretionary), and the focus of the quantitative approach is on factors across a potentially large group of stocks (whereas fundamental strategies focus on a relatively small group of stocks). In contrast, fundamental analysis (not quantitative analysis) emphasizes forecasting future prospects, including the future earnings and cash flows of a company.
Q.
Nowacki’s most appropriate response to Knight’s question about the quantitative investment process is to:
A.back-test the new strategy.
B.define the market opportunity.
C.identify the factors to include and their weights.
Solution
B is correct. The first step in creating a quantitative, active strategy is to define the market opportunity or investment thesis. Then, relevant data is acquired, processed, and transformed into a usable format. This step is followed by back-testing the strategy, which involves identifying the factors to include as well as their weights. Finally, the strategy performance should be evaluated using an out-of-sample back-test.
Q.
In Nowacki’s back-testing of the factor-based strategy for the new fund, the calculated information coefficient should be based on:
A.FS(t) and SR(t).
B.FS(t) and SR(t + 1).
C.SR(t) and FS(t + 1).
Solution
B is correct. The purpose of back-testing is to identify correlations between the current period’s factor scores, FS(t), and the next period’s holding period strategy returns, SR(t + 1).
Q.
Nowacki’s calculated price/book ratios (P/Bs) and price/earnings ratios (P/Es), in his back-testing of the new strategy, are a problem because of:
A.data mining.
B.look-ahead bias.
C.survivorship bias.
Solution
B is correct. Look-ahead bias results from using information that was unknown or unavailable at the time the investment decision was made. An example of this bias is using financial accounting data for a company at a point before the data were actually released by the company. Nowacki computed historical P/Bs and P/Es using calendar year-end (31 December) stock prices and companies’ financial statement data for the same calendar year, even though the financial statement data for that calendar year were likely unavailable at year-end.
Data mining refers to automated computational procedures for discovering patterns in large datasets, which can introduce a bias known as overfitting. Survivorship bias occurs when back-testing uses companies that are in business today but ignores companies that have left the investment universe.
Q.
Based on Exhibit 1, which stock pair should Knight recommend as the best candidate for statistical arbitrage?
A.Stock 1 and Stock 2
B.Stock 3 and Stock 4
C.Stock 5 and Stock 6
Solution
B is correct. Knight should recommend the Stock 3 and Stock 4 pair trade. Two stocks make for an ideal pairs trade if (1) the current price ratio differs from its long-term average and shows historical mean reversion and (2) the two stocks’ returns are highly correlated. The relationship between Stock 3 and Stock 4 meets these conditions.
Q.
The most appropriate response to Knight’s question regarding the potential future scenario for the Heydon Quant Fund is:
A.only the returns-based approach.
B.only the holdings-based approach.
C.both the returns-based approach and the holdings-based approach.
Solution
C is correct. Because the Heydon Quant Fund would be changing its factor model by adding a new factor, the correlations of the fund’s returns with the factors would likely change and the returns-based style would change. Even though the investment universe is unchanged, the portfolio holdings would likely change and the holdings-based style classification would also will be affected.
Allfunz Consulting Case Scenario
Allfunz Consulting Partners provides advice to primarily long-term investors in regard to active investment strategies and managing active risk. Reed Leeter, a senior consultant, is discussing active strategies with a client, Peter Clickman.
Leeter makes the following statements about quantitative strategies:
Manager experience and discretion in identifying new trends in the market are important components of any quantitative strategy.
Loss aversion bias is more prominent with quantitative strategies than with fundamental strategies.
Generally, quantitative methods rely on information coefficients between firm returns and model factors.
Leeter tells Clickman about the interesting investment process of the XTZZ Fund. Leeter states that many times, government-reported data are revised three to six months after the data are initially reported. These revisions then become incorporated into the historical data, with the revised value replacing the originally reported value. When the revision is incorporated, the data are referred to as “clean data.” XTZZ applies its analysis in a manner in which the originally reported data exist as a lagged factor until the revised data become available. This approach differentiates XTZZ from funds that use only the “clean” data, which ignore the initially reported data values.
Next, Leeter describes the investment approach of the Kopernicus Fund. Kopernicus makes extensive use of market data to support its primary focus—pairs trading between industry peers. Statistical techniques identify two securities that have been highly correlated with each other in the past. If the price relationship between a pair diverges, Kopernicus expects mean reversion over a few days or weeks and places long–short positions accordingly to take advantage of the divergence.
Leeter then uses a firm-generated brochure (Exhibit 1) to inform Clickman about some other potential funds that may interest him.
Exhibit 1
Funds in Brochure
Firm
Description
Altitude Funds
Uses the 12-month forward price-to-earnings ratio (P/E) over the forecasted earnings per share (EPS) to select stocks.
Pioneer Funds
Compares a company P/E with an industry average P/E in order to invest in firms that are under-priced.
Regulas Funds
Invests in a combination of global equity securities from 5–10 different countries. Portfolio weights are adjusted to take advantage of companies that appear to have the best near-term growth prospects.
Leeter states that although Altitude Funds and Pioneer Funds both use P/Es in their strategies, both funds incorporate a growth strategy.
Clickman asks Leeter how Regulas Funds determines its equity selections. Leeter says that Regulas uses monthly data from non-traditional, but measurable, sources to determine the influence of customer and government attitudes toward a firm and its products. Leeter also notes that Regulas compares its performance relative to an equity benchmark customized to its strategy and that the factors tend to be more volatile than traditional market factors. He also states that the fund does tend to suffer in performance when exchange rates are volatile.
Clickman then asks Leeter how he should determine the style of the funds he is considering. Leeter responds, “The best way to determine the style of the funds is to perform a returns-based analysis by regressing the past returns on the funds against the past returns on a number of style indexes to determine which styles are most prevalent within each fund. Unfortunately, this method tends to not be as easy to perform as holdings-based analysis. However, returns-based analysis allows for a deeper level of analysis relative to holdings-based analysis.”
Question
Which of Leeter’s statements concerning the quantitative approach to active management is most accurate?
A. Statement 1
B. Statement 2
C. Statement 3
Solution
C is correct. Leeter’s third statement is most accurate. Generally, quantitative methods use past data to identify systematic factors that can be overweighted or underweighted in a portfolio based on an information coefficient.
A is incorrect. Leeter’s first statement is not accurate. Manager discretion has a minimal role in quantitative approaches.
B is incorrect. Leeter’s second statement is not accurate. Loss aversion is more symptomatic of fundamental approaches rather than quantitative approaches.
Active Equity Investing: Strategies Learning Outcomes
Compare fundamental and quantitative approaches to active management
Describe how quantitative active investment strategies are created
XTZZ’s approach to analyzing government-reported data most likely reduces:
A.look-ahead bias.
B.survivorship bias.
C.model overfitting.
Solution
A is correct. XTZZ’s approach prevents the use of “revised” government data that are not known when the data are initially reported. By not incorporating revised government data until they are actually revealed, XTZZ reduces look-ahead bias.
B is incorrect. Survivorship bias occurs when analysis on past data ignores firms that have ceased to exist at some point during the analysis period.
C is incorrect. Model overfitting occurs when the model fits the past data by finding a pre-conceived relationship (i.e., making the model specifications biased toward the pre-conceived relationship) or when the model is biased toward patterns that are specific only to the past data.
Active Equity Investing: Strategies Learning Outcome
Describe how quantitative active investment strategies are created
Which risk management method is the Kopernicus Fund most likely to use to offset the primary risk of its strategy?
A.Proper identification of the pairs
B.Frequent use of stop-loss order rules
C.Extensive analysis of the limit order book
Solution
B is correct. The biggest risk in pairs trading is that the observed price divergence is not temporary and could be due to structural reasons. Frequent use of stop-loss rules, which are set to exit trades when a loss limit is reached, addresses this risk.
A is incorrect. Although proper identification of the pairs to be used is critical to the success of this statistical arbitrage strategy, the selection process alone does nothing to address the risk that changes in fundamentals between the companies in the pair may occur, thereby extending (or eliminating) price convergence.
C is incorrect. Using the limit order book to identify pairs pricing anomalies implies a very short time frame—as brief as a few milliseconds—and focuses on high-frequency trading. Kopernicus lets trades play out for days or weeks; therefore, using the limit order book will not help it.
Active Equity Investing: Strategies Learning Outcome
Describe active strategies based on statistical arbitrage and market microstructure
Using Exhibit 1, Leeter’s statement about Altitude Funds and Pioneer Funds is most likely:
A.
correct.
B.
incorrect in regard to Altitude Funds.
C.
incorrect in regard to Pioneer Funds.
Solution
C is correct. The statement is incorrect in regard to Pioneer Funds but is correct in regard to Altitude Funds. Pioneer Funds uses a relative value strategy (i.e., seeks under-priced securities relative to an industry value benchmark) that has no aspects of a growth strategy. Altitude Funds uses a hybrid of value strategies (use of P/E) and growth strategies (use of forward EPS) known as GARP (growth at a reasonable price).
A is incorrect. The statement is incorrect in regard to Pioneer Funds but is correct in regard to Altitude Funds. Pioneer Funds uses a relative value strategy (i.e., seeks under-priced securities relative to an industry value benchmark) that has no aspects of a growth strategy.
B is incorrect. The statement is incorrect in regard to Pioneer Funds but is correct in regard to Altitude Funds. Altitude Funds uses a hybrid of value strategies (use of P/E) and growth strategies (use of forward EPS) known as GARP (growth at a reasonable price).
Active Equity Investing: Strategies Learning Outcome
Analyze bottom-up active strategies, including their rationale and associated processes
Using Exhibit 1 and the equity selection process of Regulas Funds, the strategy will most likely benefit from:
A.
a portfolio overlay.
B.
a new benchmark.
C.
using annual rebalancing.
Solution
A is correct. Regulas Funds will benefit from a portfolio overlay of derivative securities to eliminate exchange rate risk.
B is incorrect. Regulas uses a custom benchmark that is already appropriate for its strategy.
C is incorrect. Annual rebalancing is too infrequent given the volatile nature of the factors used by Regulas.
Active Equity Investing: Strategies Learning Outcome
Analyze factor-based active strategies, including their rationale and associated processes
Leeter’s reply to Clickman concerning determining the style of funds is most accurate in regard to the:
A. description of a returns-based analysis.
B. applicability of returns-based analysis versus holding-based analysis.
C. comparison of depth of analysis between returns-based analysis versus holdings-based analysis.
Solution
A is correct. Leeter’s reply is correct in regard to the description of returns-based analysis. Regressing a fund’s past returns against the past returns from a number of style indexes is a returns-based style analysis.
B is incorrect. Leeter’s reply is incorrect in regard to the applicability of returns-based analysis versus holdings-based analysis. Returns-based analysis is easier to implement than holdings-based analysis because data are more readily available.
C is incorrect. Leeter’s reply is incorrect in regard to the comparison of depth analysis between the two methods. Holdings-based analysis allows for a deeper level of analysis when compared with returns-based analysis because holdings-based analysis uses the actual portfolio holdings. The analysis is more accurate and generates more information for making style allocation decisions.
Active Equity Investing: Strategies Learning Outcome
Discuss equity investment style classifications
Grasmere Asset Management Case Scenario
Morgan Abernathy, Nathaniel Granville, and Gabriella Carlucci are analysts at Grasmere Asset Management (Grasmere), an investment firm that offers a diversified mix of actively managed equity and fixed-income investment funds. The firm follows the fundamental approach, using both bottom-up and top-down investment management strategies. The analysts meet regularly to discuss investment ideas and related topics.
The meeting begins with a discussion of the fundamental approach to active equity management strategies. The analysts make the following statements:
The approach is a subjective investment process that uses discretion in making decisions.
The portfolio manager’s selections are based on determining a security’s exposure to selected variables that predict its return.
The construction of a portfolio is generally done using a portfolio optimizer, which controls risk at the portfolio level.
The analysts then review Exhibit 1, which describes a selection of the Grasmere equity funds.
Exhibit 1
Grasmere Equity Funds
Fund Name
Fund Description
Fund A
The fund primarily invests in the stocks of companies with poor earnings performance that are out of favor with the market and appear to be influenced by investor behavioral trends. Stocks are selected on the basis of company analysis by Grasmere’s analysts. The fund uses sector overlays to control risk.
Fund B
The long–short fund seeks to profit from the market inefficiencies that may arise as a result of such corporate events as asset divestitures, mergers and acquisitions, special dividend payments, and share repurchases. The fund utilizes software that searches news sources to identify target companies that are then analyzed by the firm’s analysts.
Fund C
The fund invests globally on the basis of country and sector parameters set by the firm’s investment strategist. The allocations are adjusted periodically on the basis of economic growth prospects and expected sector profitability. The portfolio manager selects the most promising stocks based on his or her judgement and experience.
Fund D
The fund primarily invests in companies identified by Grasmere’s analysts that exhibit above-average growth potential and trade at reasonable valuation multiples.
The analysts made the following points about the potential investments that Fund B might undertake. The fund should be interested in
investing in the shares of a potential acquirer, even in a consolidating industry;
taking a control position in a distressed company’s shares selling at a deep discount to its intrinsic value; and
using its expertise to make long-term investments involving companies in reorganization.
Grasmere’s larger funds have had an impressive long-term record compared with peers. In more recent times, however, the results have been lagging. Positions have become more concentrated than in the past, and the proportion of positions underperforming their respective industries has increased. Carlucci believes managers may have become subject to two biases: an illusion of control and confirmation bias. Carlucci asks Abernathy what steps he could recommend to address the effect of these biases.
The final topic involves a discussion of some high-profile companies that recently released their full-year earnings results. Exhibit 2 contains market data and financial projections on three of the stocks discussed by Grasmere’s analysts. They are considering adding one of these stocks to Fund D.
Exhibit 2
Market Data and Financial Projections of Selected Stocks
Stock Symbol
Price
12-Month Forward EPS
3-Year EPS Growth Forecast
Sector Average P/E
Sector Long-Term Growth Forecast
AQU
$36
$3.70
9.50%
11.4
8.00%
BRW
$28
$2.75
12.00%
10.1
14.00%
CSY
$19
$1.95
11.25%
10.8
10.00%
Question
Which of the analysts’ statements regarding the fundamental approach is the most accurate?
Solution
A is correct. Statement 1 is correct. The fundamental approach is a subjective investment process that uses discretion in making decisions.
B is incorrect. Statement 2 in incorrect. Determining a security’s exposure to selected variables that predict its return is a quantitative, not a fundamental, approach to active equity management.
C is incorrect. Statement 3 is incorrect. Using a portfolio optimizer to control the risk in the construction of a portfolio is a quantitative approach.
Active Equity Investing: Strategies Learning Outcome
Compare fundamental and quantitative approaches to active management
Based on the descriptions in Exhibit 1, which fund is least likely to use a combination of a top-down and a bottom-up strategy?
Solution
B is correct. Fund B uses only a bottom-up approach. Searching news sources is used only to identify target companies that are then analyzed by the firm’s analysts.
A is incorrect. Fund A uses a combination of the bottom-up and top-down approaches. The selection of stocks based on company analysis is a bottom-up approach, whereas the use of overlays to control risk is a top-down approach.
C is incorrect. Fund C uses a combination of the top-down and bottom-up approaches. The fund invests globally on the basis of country and sector parameters set by the investment strategist, which is a top-down approach. The subsequent selection of stocks by the portfolio manager based on judgement and experience is a bottom-up approach.
Active Equity Investing: Strategies Learning Outcome
Analyze bottom-up active strategies, including their rationale and associated processes
As described in Exhibit 1, Fund A most likely follows which investment strategy?
A.
Contrarian
B.
Deep value
C.
Restructuring and distressed
Solution
A is correct. Fund A most likely follows the contrarian investing approach. Contrarian managers invest in stocks with low or negative earnings or low dividends. Contrarians expect the stocks to rebound once the company’s earnings rebound. Contrarian investors often point to behavioral finance research that suggests that investors tend to overweight recent trends and follow the crowd in making investment decisions. Therefore, contrarian investors purchase and sell shares against prevailing market sentiment.
B is incorrect. Deep value investing focuses on undervalued companies, which are often in financial distress, that are available at extremely low valuations relative to their assets. The rationale is that market interest in such securities may be limited, which increases the chance of informational inefficiencies.
C is incorrect. Opportunities in restructuring and distressed investing are generally counter-cyclical relative to the overall economy or a sector’s business cycle. A distressed company that goes through restructuring may still have valuable assets, distribution channels, or patents that make it an attractive acquisition target. The goal of restructuring investing is to gain control or substantial influence over a company in distress at a large discount and then restructure it to restore a large part of its intrinsic value.
Active Equity Investing: Strategies Learning Outcome
Analyze bottom-up active strategies, including their rationale and associated processes
In the analysts’ discussion about Fund B’s potential investments, the point that is most accurate relates to:
A.
reorganization opportunities.
B.
positions in distressed companies.
C.
acquisitions in a consolidating industry.
Solution
C is correct. Fund B fund seeks to profit from the market inefficiencies that may arise as a result of corporate events. It can hold either long or short positions in the acquiring and target companies as appropriate to produce a profitable position. This would be true even in consolidating industries as long as it believed that a market inefficiency existed.
A is incorrect. Fund B fund seeks to profit from the market inefficiencies that may arise as a result of corporate events. Investing in reorganizations requires skill and expertise but normally involves a long-term investment horizon, which is inconsistent with Fund B’s strategy.
B is incorrect. Fund B fund seeks to profit from the market inefficiencies that may arise as a result of corporate events. A control position in a distressed company would normally involve a long-term investment horizon, which is inconsistent with Fund B’s strategy.
Active Equity Investing: Strategies Learning Outcome
Analyze bottom-up active strategies, including their rationale and associated processes
Which of the following steps is Abernathy least likely to recommend to address the behavioral biases that Carlucci believes exist in the larger funds?
Solution
A is correct. Establishing stop-loss rules is most likely to address loss aversion bias, which is an emotional bias whereby investors tend to prefer avoiding losses over achieving gains. Stop-loss rules do not address illusion of control or confirmation bias.
B is incorrect. Illusion of control refers to the human tendency to overestimate one’s ability to select stocks, influence outcomes, and outperform the market. An illusion of control could lead to excessive trading and heavy weighting on a few stocks. Investors should enforce proper trading and portfolio diversification rules to try to avoid this problem.
C is incorrect. Confirmation bias is the tendency of investors to look for information that confirms their existing beliefs about their favorite companies and ignore or undervalue any information that contradicts their existing beliefs. The consequences of confirmation bias are a poorly diversified portfolio, excessive risk exposure, and holdings in poorly performing securities. Actively seeking the opinions of other team members or other information to challenge existing beliefs will help mitigate this bias.
Active Equity Investing: Strategies Learning Outcome
Describe how quantitative active investment strategies are created
Using Exhibits 1 and 2, the stock that would be the best addition to Fund D is:
PE -
AQU - 9.73
BRW - 10.18
CSY - 9.74
Solution
C is correct. Fund D follows the GARP (growth at a reasonable price) strategy, which seeks out companies with above-average growth that trade at reasonable valuation multiples. Many investors who use GARP rely on the P/E-to-growth (PEG) ratio.
AQU’s forward P/E is 36 ÷ 3.70 = 9.73, and its PEG ratio is 9.73 ÷ 9.50 = 1.02.
BRW’s forward P/E is 28 ÷ 2.75 = 10.18, and its PEG is 10.18 ÷ 12.0 = 0.85.
CSY’s forward P/E is 19 ÷ 1.95 = 9.74, and its PEG is 9.74 ÷ 11.25 = 0.87.
Although lower PEG ratios are preferred and BRW has a slightly lower PEG ratio than CSY, BRW’s EPS growth forecast of 12.00% is below the sector long-term growth forecast of 14.00% whereas CSY’s EPS growth forecast of 11.25% is above the sector long-term growth forecast of 10.00%. Given CSY’s combination of above-average growth and a reasonable valuation multiple, it would be the best addition to Fund D.
A is incorrect. AQU has the highest PEG ratio; lower PEG ratios are preferred.
B is incorrect. Although BRW has a slightly lower PEG ratio than CSY, BRW’s EPS growth forecast of 12.00% is below the sector long-term growth forecast of 14.00% whereas CSY’s EPS growth forecast of 11.25% is above the sector long-term growth forecast of 10.00%.
Active Equity Investing: Strategies Learning Outcome
Analyze bottom-up active strategies, including their rationale and associated processes
Why Sector Growth Matters
If a company's growth forecast is below the sector long-term growth forecast, it means the company is expected to grow slower than the average company in that sector. This is a negative sign because we want companies that are leaders in their sector, not lagging behind.
If a company's growth forecast is above the sector long-term growth forecast, it means the company is expected to grow faster than the average company in the sector. This is a positive sign because it indicates strong potential.
Monica Popkirk Case Scenario
Monica Popkirk directs the equity manager selection team of PV-America Wealth Management (“PV”). She and her analysts evaluate, classify, and recommend funds to the PV investment committee. PV has asked Popkirk to broaden the selection of approved funds for its investment advisers to use in client portfolios and also to include some alternative asset classes by possibly using some hedge funds.
Popkirk and her team examine the fund descriptions and consider both holdings-based and returns-based approaches to style classification. Intending to select a top-down fundamentally driven manager, she considers three candidates from Lunnar Associates, as shown in Exhibit 1.
Exhibit 1
Lunnar Associates Funds under Consideration
Fund
Description
Lunnar A
Value-weighted combination of 10 different country indexes with a low fee structure: It is rebalanced annually.
Lunnar B
Strategically weighted combination of 10 different country indexes: The portfolio weights are adjusted to take advantage of consensus views of what are perceived as long-term trends in the global economy and also to take advantage of short-term opportunities.
Lunnar C
Strategically weighted combination of global equity securities from 5–10 different countries: Using a fundamental approach, the portfolio weights are adjusted to take advantage of companies that appear to have the best near-term growth prospects.
Beyond the fund descriptions, Popkirk instructs her team to assemble an analysis table to help determine which of Lunnar’s funds has the closest fit to the style of its chosen benchmark index. She points out that all three of these funds are long only with well-known and accepted style box categories. Data are provided for both the holdings-based style analysis of the current portfolio and the returns-based style analysis based on 36 months of historical returns and are shown in Exhibit 2.
Exhibit 2
Lunnar Fund Style Analysis
Fund
Holdings-Based Value/Growth Mix
Returns-Based Value/Growth Mix
Index Value/Growth Mix
Lunnar A
68%/32%
68%/32%
75%/25%
Lunnar B
67%/33%
68%/32%
65%/35%
Lunnar C
39%/61%
34%/66%
35%/65%
Popkirk explains to her analysts that the better active fund managers wisely consider what pitfalls and behavioral biases may readily affect their strategies and those of their competitors. For instance, when evaluating the fundamental approach used by Lunnar C, Popkirk says that analysts should look for evidence that one of the following three biases have been acknowledged and addressed by the manager: survivorship bias, confirmation bias, or look-ahead bias.
Digging deeper into another one of Lunnar’s funds, Popkirk’s analysts review and discuss the Lunnar fund’s annual reports for the last six years. One of the reports noted, “During the last recession, we rotated into deep-value companies likely to deliver superior returns as a risk-on environment returned.”
The analysts then make the following comments:
Analyst 1: “The fund is following a top-down approach.”
Analyst 2: “I disagree. The emphasis on economic analysis is consistent with top down, but because it uses deep-value stocks, the approach is clearly bottom up.”
Analyst 3: “After reading the reports for all years, I was left thinking that overall they are GARP managers—growth at a reasonable price—which is top down.”
One of PV’s committee members has asked Popkirk for her thoughts as to which style classification should be used when describing Lunnar’s popular hedge fund, the Lunnar Hedge-X fund. It uses a variety of techniques to achieve alpha, including long–short equity portfolios with substantial futures and options overlays to control risk. Lunnar suggests its clients use a combination of the Lunnar Hedge-X fund along with its more traditional funds to improve the Sharpe ratio of its overall portfolios.
Boris Thompson, one of the Lunnar managers, claims to have had consistent success in beating his benchmark by using price momentum as a rewarded equity factor exposure. Popkirk warns her analysts that the manager may not be truly forthcoming regarding some periods of underperformance.
Question
Based on the information in Exhibit 1, which of the funds from Lunnar Associates most likely follows a top-down fundamental approach?
Solution
B is correct. Lunnar B uses a top-down fundamental approach because it requires manager discretion in considering future long-term trends and short-term opportunities in the global economy (i.e., a fundamental approach). The strategy is executed by using different portfolio weightings on indexes rather than individual corporate securities, making it top down rather than bottom up.
A is incorrect. Lunnar A is passively managed because the portfolio weights are set without input from the fund manager’s future beliefs.
C is incorrect. Lunnar C is actively managed but uses a bottom-up strategy focused on the expected future prospects of individual securities.
Active Equity Investing: Strategies Learning Outcome
Analyze top-down active strategies, including their rationale and associated processes
Which of the funds in Exhibit 2 has a style most consistent with that of its respective index?
A. Lunnar A
B. Lunnar B
C. Lunnar C
Solution
B is correct. Lunnar B has a style most consistent with its index. Holdings-based style analysis is generally more accurate than returns-based style analysis because it uses the actual portfolio holdings. With holdings-based style analysis, portfolio managers can see how each portfolio holding contributes to the portfolio’s style and verify that the style is in line with the stated investment philosophy. Returns-based style analysis is preferred when the full details of the portfolio are not available. Lunnar B’s holdings-based mix is closest to its index style (2% variance, compared with Lunnar A’s 7% and Lunnar C’s 4%).
A and C are incorrect for the reasons stated above.
Active Equity Investing: Strategies Learning Outcome
Discuss equity investment style classifications
Evidence of which behavioral bias is most likely to be found when analyzing the Lunnar C fund?
Solution
C is correct. Confirmation bias, a cognitive error sometimes referred to as “stock love bias,” is the tendency of fundamental-based analysts and investors to look for information that confirms their existing beliefs about their favorite companies and to ignore or undervalue any information that contradicts their existing beliefs. Both look-ahead bias and survivorship bias are risks inherent in backtesting quantitative active strategies.
A is incorrect. Survivorship bias is a risk inherent in backtesting a quantitative active strategy. This approach creates a bias whereby only companies that have survived are tested and it is assumed that the strategy would never have invested in companies that have failed. Survivorship bias often leads to overly optimistic results and sometimes even causes investors to draw wrong conclusions.
B is incorrect. Look-ahead bias is a risk inherent in backtesting a quantitative active strategy. This bias results from using information that was unknown or unavailable at the time an investment decision was made. An example of this bias is the use of financial accounting data for a company at a point in time before the data were actually released by the company.
Active Equity Investing: Strategies Learning Outcome
Describe how fundamental active investment strategies are created
Which of the analysts’ comments regarding the Lunnar fund’s annual report is the most accurate?
Solution
A is correct. The comment made by Analyst 1 is correct regarding style rotation into deep value as motivated by the economic cycle. This is a top-down strategy.
B is incorrect. The comment by Analyst 2 ignores that the use of deep value here is a consequence of style rotation driven by economic analysis, which is top down.
C is incorrect. The comment by Analyst 3 is inaccurate because GARP is a bottom-up strategy.
Active Equity Investing: Strategies Learning Outcome
Analyze top-down active strategies, including their rationale and associated processes
Which method of style analysis is best used to properly classify the Lunnar Hedge-X fund?
Solution
A is correct. Self-identification is the best way to classify Lunnar Hedge-X’s strategy. As a non-standard hedge fund that extensively uses short positions and derivatives, the description in the fund’s prospectus becomes the key source of information for those assigning a style. Neither a holdings-based approach nor a returns-based approach is likely to help classify Lunnar Hedge-X’s approach.
B is incorrect. As a non-standard hedge fund that extensively uses short positions and derivatives, the description in the fund’s prospectus becomes the key source of information for those assigning a style. A holdings-based approach is not going to help classify Lunnar Hedge-X’s approach.
C is incorrect. As a non-standard hedge fund that extensively uses short positions and derivatives, the description in the fund’s prospectus becomes the key source of information for those assigning a style. Neither a holdings-based approach nor a returns-based approach will help classify Lunnar Hedge-X’s approach.
Active Equity Investing: Strategies Learning Outcome
Discuss equity investment style classifications
Solution
C is correct. The use of the rewarded factor price momentum is subject to extreme tail risk.
A is incorrect. The value trap refers to the appearance of a cheap value and is not associated with price momentum.
B is incorrect. The growth trap refers to stocks that appear to have continuing growth in earnings, not price.
Active Equity Investing: Strategies Learning Outcome
Analyze factor-based active strategies, including their rationale and associated processes
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