APPROACHES TO ACTIVE INVESTMENT Active investing strategies are divided into two categories fundamental and quantitative.. Differences between Fundamental and Quantitative approaches D
Trang 1Reading 28 Active Equity Investing Strategies
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Two broad approaches to active equity investing
strategies are fundamental and quantitative The
objective of both approaches is to outperform a passive
benchmark, however, both approaches tend to make investment decisions differently
2 APPROACHES TO ACTIVE INVESTMENT
Active investing strategies are divided into two
categories fundamental and quantitative
Fundamental approaches tend to involve human
judgment and are often stated as ‘discretionary’
Fundamental approaches are based on research into
companies, industries, sectors or markets and use
valuation models such as (free cash flow models),
quantitative screening tools, statistical techniques (such
as, a regression analysis)
Fundamental approach often starts with the analysis of
company’s financial statements to comprehend
company’s profitability, financial position, cash flows This
approach attempts to find company’s future business
outlook by examining the company’s business model,
product lines, management competence, economic
viewpoint The intrinsic value of the stock is then
estimated and compared to the peer group or the
stock’s own historical values Based on these valuations,
the decision is made concerning whether to buy or sell
the stock or overweight/underweight relative to the
benchmark
The valuation process of fundamental analysis can be
classified as top-down or bottom-up depending on their
starting point Top down approach starts by analyzing
markets, industries, or economies whereas bottom-up
approach begins with individual stocks to identify
opportunity
Quantitative approaches make use of rules-based
quantitative models and are often stated as
‘systematic’ Quantitative approaches rely on computer
programs to develop models that have predictive
power to recognize market or security features and
patterns to identify securities that are expected to earn
higher returns relative to the benchmark These
approaches use variables that relate to company
fundamentals Variables may include:
• valuation metrics (e.g., earning yield)
• size (e.g., market capitalization)
• profitability metrics (e.g., return on equity)
• financial strength metrics (e.g., debt-to-equity
ratio)
• market sentiment (e.g., analyst consensus)
• industry membership (e.g., stock’s GICS
classification)
• price-related attributes (e.g., price momentum)
Investment success of this approach depends on the model quality i.e how accurately the model predicts future expected returns of securities
Note: The labels fundamental and quantitative are
confusing in the sense that both approaches use quantitative tools and models
Some hybrid approaches combine elements of
fundamental and quantitative approaches
Differences between Fundamental and Quantitative approaches
Differences between Fundamental
and Quantitative approaches
Fundamental Qualitative
Decision-making process
Primary Resources Human judgment skills Statistical Modeling skills
Information used Research (company,
industry, economy)
Data & statistics
Analysis Focus Conviction in stock, sector, or
region-based selection
Variables (applying over a number
of securities)
Orientation
to data Forecasting views on
companies &
corporate parameters
Drawing conclusions from a variety
of historical data
Portfolio Construction Use judgement within
acceptable risk parameters
Use optimizers
Reference: CFA Institute’s Curriculum, Reading 28, Exhibit
1
Trang 22.1 Differences in the Nature of the Information Used
Typical activities for investors using fundamental
approaches (bottom-up or top down) and quantitative
approaches are given below
Bottom-up fundamental investors assess a company
using its recent financial statements and disclosures for
attributes such as profitability, leverage, absolute or
relative valuation to identify trends, to scrutinize
management’s competence and the company’s future
prospects
Top-down fundamental investors’ research typically
begins by analyzing region, sector, economic or macro trends
Quantitative approaches use historical data and
statistical techniques Usually, the data is processed systematically to identify variables that are statistically significant with the stock returns
Historical data for quantitative research should use original accounting data and should include stocks that
no longer exist to minimize look-ahead and survivorship biases
Investment Process: Fundamental vs Quantitative
2.2 Difference in the Focus of the Analysis
Fundamental investors typically perform in depth analysis
on a small group of stocks Take large positions in
selected stocks
Quantitative investors focus on factors across a large
group of stocks Spread their selected factor bets across
large number of holdings
2.3 Forecasting the future vs Analyzing the Past Difference in Orientation to the Data:
Fundamental approach intends to make investment
decisions by forecasting future parameters (e.g future
earnings, cash flows, growth, company’s outlook) using
knowledge, judgment, in-depth analysis
Quantitative approach intends to predict future returns
by analyzing historical data using models (i.e back-testing past data), considering analysts’ reports about future earnings estimates that have been published
2.4 Differences in Portfolio Construction: Judgement vs Optimization
Fundamental investors’ major risk is at company level as
stocks are usually high-conviction stocks Stock selection process involve extensive research on individual
companies however risk may exist that analyst’s earnings
or fair value estimates are incorrect, or market fails to recognize reasons for mispriced stocks
Manager monitor portfolio holdings continuously i.e increase or decrease positions at any time
Quantitative investors’ risk is that factor returns may not perform as expected The risk lies at portfolio level as the
approach invests in larger group of holdings To control
Trang 3risk at portfolio level, this approach applies portfolio
optimization i.e selecting the best portfolio out of set of
portfolios
Portfolios are usually rebalanced at regular intervals
3 TYPES OF ACTIVE MANAGEMENT STRATEGIES
Equity investors have established different procedures or
may take into account multiple approaches to
formulate their opinions about stocks Many
fundamental and quantitative strategies can be
categorized as either bottom-up or top-down
3.1 Bottom-Up Strategies
Bottom-up investing begins the asset selection process
by focusing on attributes such as price momentum,
profitability at the individual stocks
Bottom-up quantitative investors use computer programs
to apply their models to the asset or company-level
information, which is usually quantifiable
Bottom-up fundamental investors rely on analyst’s
in-depth knowledge and ability to identify companies with
strong or weak fundamentals Then the analysts consider
economic & financial elements to evaluate the selected
companies’ intrinsic value and compare them with their
current market prices to identify under or overvalued
stocks
Analysts may find operationally efficient (inefficient)
companies with healthy (poor) future outlook belonging
to deteriorating (booming) industries
Fundamental investors focus on one or more of the
following three parameters:
• business model and branding
• competitive advantages
• company management and corporate
governance
Business Model and Branding:
Business model refers to the company’s overall strategy
to run business and generate profits Business model
analysis provides insight about the company’s
operations, structure of the value chain, branding
strategy, market segments, business scalability etc Such
information help investors in forming opinions about the
company’s competitive advantages and sustainability
Corporate branding serves to define company’s identity
and its promises to customers Strong brand names allow
companies to charge price premiums
Competitive Advantages:
Competitive advantage is a superiority a company has
over its peers There are many types of competitive
advantage such as approach to natural resources, technology, innovation, competent workforce, reputation, brand name, high barriers to entry, superior product etc
Investors should explore sustainable competitive advantage for a company’s long-term success, especially value investors who select companies trading below their intrinsic value
Company Management
A competent management maximizes the growth of enterprise value for the company’s shareholders Indicators that measure the management’s performance include return-on-assets, equity, invested capital, earnings growth etc
Qualitative evaluation of the company’s management and governance structure include:
• Management’s interest towards minimizing agency issues
• Management’s competence to achieve long-term objectives
• Management’s stability and retention of high-performing executives
• Managing ESG considerations and related risks and opportunities
Bottom-up fundamental investors value stocks by applying single or combination of approaches such as discounted cash-flow, dividend models, or earnings-related valuation metrics i.e P/E, price to book, EV/EBITDA
Bottom-up strategies are broadly classified as:
i) value-based approaches ii) growth-based approaches
3.1.1.) Value-Based Approaches
Value-based investors tend to buy stocks trading at a significant discount to their estimated intrinsic value Value-based investors exploit opportunities may arise as
a result of other investors’ irrational behaviors e.g overreaction to negative news
Some value-based approaches are given below
3.1.1.1.) Relative Value
Investors following relative-value approaches compare
a company’s multiple to that of the average value of
Practice: Example 1, CFA Curriculum, Volume 4, Reading 28
Trang 4the sector Some common value indicators are P/E, P/B,
current ratio, P/CF, D/E, dividend yield etc Average
valuation multiples may vary for different sectors
3.1.1.2.) Contrarian Investing
Contrarian investors tend to go against the crowd by
buying and selling shares in contrast to the prevailing
market sentiment Contrarian purchase poorly
performing stocks trading below their intrinsic value with
the expectation that their stock prices will rebound later,
resulting in a price appreciation
Contrarian investors just like value investors purchase(sell)
shares trading at discount(premium) to their intrinsic
value The main difference is that the contrarian investors
rely on market sentiments and sharp price movements
instead of fundamental metrics
3.1.1.3.) High-Quality Value
High-quality value investment style considers financial
strength, earnings power and top-class management in
addition to valuation
3.1.1.4.) Income Investing
Income investing approach target shares with high
dividend yields and positive dividends growth rates
Historically high dividend paying stocks have been
relatively more stable
3.1.1.5.) Deep-Value Investing
Deep-value investors look for shares selling at extremely
discounted prices e.g., shares of financially distressed
companies (low P/B) This approach is for experts who
understand their strategy well
3.1.1.6.) Restructuring and Distressed Investing
Restructuring investors purchase debt or equity of a
distressed company at a large discount with an aim to
gain control over a company and then restructure it to
restore the company’s intrinsic value
Distressed investors tend to identify companies heading
into distress that still have sufficient assets upon
liquidation
3.1.1.7.) Special Situations
Investors following ‘special situations’ investment style
tend to recognize opportunities (often short-term) arise
as a result of corporate situations such as divestitures,
spinoffs of assets or divisions, mergers This investment
style requires skill and expertise in identifying pertinent
company
3.1.2.) Growth-Based Approaches
Growth-based investors focus on high-quality companies
that are expected to grow faster than their industry or
overall market analyzed by growth in earnings, revenues
or cash flows, above average return on equity Growth
investors generally look for are companies with
consistent growth or companies with strong earnings
momentum Growth investors may invest in companies
with high price multiples if they find growth prospects attractive
GARP (growth at a reasonable price) also referred as
hybrid of growth and value investing is a sub-category of growth investing GARP investors search for above-average growth companies trading at reasonable valuation multiples PEG ratio calculated as
!/#
Top-down investment process begins at macro level Top-down investors focus on variables such as macroeconomic factors, demographic trends, government policies Top down managers often use instruments such as futures contracts, ETFs, swaps and custom baskets of individual stocks
3.2.1) Country and Geographic Allocation to Equities
Investors following this strategy invest in various geographic regions or countries based on the regions’ prospects Managers following this strategy analyze supply and demand for equities in different countries
3.2.2) Sector and Country Rotation
This strategy is based on investor’s view on the expected returns of different sectors and industries on global basis Some industries are suitable to global sector allocation decisions e.g IT industry, energy sectors whereas other sectors or industries are appropriate for sector allocation within a country e.g real estate or consumer staples etc Some managers implement sector and industry rotation strategy by investing in sector and industry ETFs instead
of buying individual stocks of pertinent industries or sectors
3.2.3) Volatility-Based Strategies
Investors using this strategy form portfolios based on their views on volatility usually through derivative instruments Skill and expertise are required to predict future market volatility better than option-implied volatility
For example, an investor who anticipates high index volatility but is not sure about the direction, can capitalize on his view by entering into a long index straddle (buying call and put option with the same strike price and expiry date)
3.2.4) Thematic Investment Strategies
Thematic investors discover investment strategies based
on some new or promising ideas or themes using macroeconomic, demographic, political drivers or bottom-up ideas on industries or sectors
It is imperative for thematic investors to observe whether
the nature of trend or any new change is structural (that
Practice: Example 2 and 3, CFA Curriculum, Volume 4, Reading 28
Trang 5have long-term impacts on market such as growth of
smartphones, tablets, cloud computing, development in
medicine etc.) or short-term (such as short-term view on
currency movements)
Portfolio Overlays:
A Portfolio overlay is a set of derivative positions
managed separately from the portfolio to attain overall
portfolio characteristics Bottom-up strategists often
control unintended macro risk exposures through
portfolio overlays Portfolio overlays are also used to
enhance active returns that are uncorrelated with the
underlying portfolio strategy
3.3 Factor-Based Strategies
A factor is any variable with which individual asset
returns are correlated They represent variables which
can be used to rank stocks for investment and predict
future returns & risk
Factors can be classified as rewarded factors – such as,
value, style, momentum, and profitability, which offer a
persistent return premium – or unrewarded factors – do
not offer a persistent return premium
A factor-based strategy aims to identify factors which
can predict stock returns and constructs portfolios which
tilts towards those factors Factor-based strategies can
employ a single factor or multiple factors
Portfolio managers who use strategies that are based on
new or innovative factors often rely on academic
research
Using data on value and growth style indices over a
28-year period, value and growth styles, which represent
traditional style factors, produced the same returns with
growth equities being more volatile Over the same
period, small-cap stocks earned marginally higher
returns than large-cap stocks but with higher risk
Equity style rotation strategies – based on the belief that
factors work well in some periods but not during others
An investment process is used to allocate to stocks
representing a style which generates positive excess
return relative to the benchmark during a period
Generally used as part of quantitative investing
Manager may be data mining if the selection of a factor
lacks common senses, i.e the factor passes statistical
backtesting but there is weak evidence on its ability to
produce returns in the future
Hedged Portfolio Approach
Most common approach to implement factor-based
portfolios Portfolio is constructed as follows:
Step 1: Select factor (s) and rank investable stock
universe stock using the factor (s)
Step 2: Divide the universe into quantile portfolios (typically quintiles or deciles)
Step 3: Weight each stock using equal-weighting or market-capitalization weighting
Step 4: A long/short hedged portfolio is formed by going long the best quantile and shorting the worst quantile
Step 5: Track the performance of the hedged portfolio
Drawbacks of the approach:
• Information contained in the bottom and top quantiles is utilized to form the hedge portfolio while information in the middle quantile is ignored
• Implicit assumption that relationship between factor and future stock returns is linear (monotonic) which is unrealistic
• Resulting portfolios tend to be concentrated
• Hedged portfolio requires managers to short stocks which may be expensive or not possible
• Portfolio is not a pure factor portfolio because
it has significant exposure to other factors Factor-tilting portfolio: Used to establish a long exposure
to a given factor with controlled tracking error Termed
as an enhanced indexing strategy – tracks the benchmark index and provides factor exposure
Factor-mimicking portfolio (FMP):
• Theoretical long/short dollar-neutral portfolio with a unit exposure to one factor and no exposure to other factors
• Drawback of the portfolio is that it can be expensive to trade as portfolio takes long/short exposure in almost every stock without
considering short availability issues or transaction costs
• Pure factor portfolio can be constructed by following FMP theory but adding liquidity and short availability constraints
3.3.1) Style Factors
3.3.1.1) Value
Value can be measured in a number of ways:
• Stocks with low P/E or high earnings yield provide higher returns, Basu (1977)
• Book-to-market ratio is a way to measure value and growth, Fama and French (1993)
Why value stocks deliver superior returns:
• Value premium exists to compensate investors for the greater likelihood that such companies will experience financial distress, Fama and French (1993, 1996)
• The effect is a result of behavioral bias on the
Trang 6part of the investor, Lakonishok, Shleifer, and
Vishny (1994)
Value factors can be constructed using fundamental
performance metrics as:
• Dividends
• Earnings
• Cash flow
• EBIT
• EBITDA
• Sales
• Adjustments for industry (and/or country) and
historical differences
Valuation ratios can be computed using historical
(trailing) or forward-looking metrics
3.3.1.2) Price Momentum
Researchers found a strong price momentum effect in
most asset classes in most countries According to
research:
• stocks that are winners over the previous 12
months tend to outperform losers (classified as
such over the past 12 months) and the
outperformance persists over the next 2 to 12
months
• short-term reversal effect: stocks that have
high price momentum tend to underperform
over the next 2 to 12 months
o this effect is attributable to behavioral
biases such as overreaction to information
Price momentum is subject to extreme tail risk
Sector-neutralized price momentum factor: Factor used
to reduce downside risk by removing the effect of sector
exposure from price momentum factor returns
3.3.1.3) Growth
Growth factors aim to measure a company’s growth
potential and can be calculated using historical growth
rates or projected forward growth rates Growth factors
can be short-term or long-term
Higher than sector or market growth is considered an
indicator of strong future stock price performance for
most metrics except assets
3.3.1.4) Quality
The accruals factor can be used as a style factor Based
on research paper on earnings quality, stock prices were
found to fail to fully reflect information contained in the
accruals and cash flow components of earnings The
performance of this factor is cyclical
Factors based on a company’s fundamental data include profitability, balance sheet, solvency risk, earnings quality, stability, sustainability of dividend payment, capital utilization, and management efficiency measures
Earnings revision – another analyst sentiment indicator which refers to the phenomenon of analysts revising their corporate earnings estimates Analysts have now started
to include cash flow revisions, sales revisions, ROE revisions, sell-side analyst stock recommendations, and target price changes as variables in the analyst sentiment category
News sentiment – Investors use natural language processing (NLP) algorithms to analyze the large volume
of news stories and quantify the news sentiment on stocks
3.3.2) Unconventional Factors Based on Unstructured Data
The rapid growth in technology and computational
algorithms has resulted in investors embracing big data –
extremely large data sets that includes structured and unstructured data Examples of unstructured data include satellite images and textual information Factor based on customer-supplier chain data is one example of an unconventional factor
3.4 Activist Strategies
Activist investors take stakes in target companies and advocate changes for the purpose of producing a gain
on the investment
Activists may want representation on company’s board
of directors in order to initiate strategic, operational, or financial structure changes Active investors may also support activities such as cost-cutting measures or asset sales and so forth
The Shareholder Activism Process:
• The process begins with investors screening companies and analyzing opportunities in the market
• The investor reviews companies carrying out
an in-depth analysis of their business and opportunities for unlocking value
• Investors then buy an equity stake in the company and start advocating for change
• Stakes above a certain threshold must be made public in certain jurisdictions
• The goal of activist investing could either be a financial gain or non-financial gain
• Activist investors aim to achieve their goals with smaller stakes rather than a full takeover bid
Practice: Example 4, CFA
Curriculum, Volume 4, Reading 28
Practice: Example 5, CFA Curriculum, Volume 4, Reading 28
Trang 7• Activist’s time horizon is shorter than a
buy-and-hold investor but the whole process can
last for several years
3.4.1.) The Popularity of Shareholder Activism
Proponents of shareholder activism argue that it is an
important and necessary activity that helps discipline
corporate management to the benefit of all
shareholders Opponent argue that activism can cause
distraction and negatively impact management
performance
Activist hedge funds are one of the most prominent
activist investors to resume their popular status following
a brief period of decline during the global financial crisis
These funds enjoy lighter regulation than other fund
types and maintain fee structures which offer greater
rewards
The popularity and viability of shareholder activism is also
influenced by:
• legal frameworks in different jurisdictions,
• shareholder structures, and
• cultural considerations
Shareholder activism is greatest in the US and visible in
Europe Other countries have a relatively limited degree
of activism due to cultural reasons and more
concentrated shareholder ownership of companies
3.4.2) Tactics Used by Activist Investors
Tactics used by activists to boost target company value
include:
• Seeking board representation and nominations
• Engaging with management by:
o Writing letters to management calling
for an explanation of suggested changes
o Participating in management
discussions
o Private meetings with management
o Launching proxy contests
• Proposing significant corporate changes
during the annual general meeting
• Proposing restructuring of the balance sheet
• Reducing management compensation or
realignment of compensation with share price
performance
• Launching legal proceedings against existing
management for breach of fiduciary duties
• Reaching out to the other company
shareholders for executing corporate action
• Launching a media campaign against existing
management practices
• Breaking up a large conglomerate to unlock
value
Effectiveness of shareholder activism depends on the response of the existing management team and the tools at the team’s disposal
Defense mechanisms available to hinder shareholder activism include:
• Multi-class share structures – a company founder’s shares are entitled to multiple votes per share
• Poison pill plans allowing the issuance of shares at a deep discount This causes economic and voting dilution
• Staggered board provisions – a portion of the board members are not elected at annual shareholder meetings
• Charter and bylaws provisions and announcements
3.4.3) Typical Activist Targets
Activist investor look for specific characteristics when looking for a target company On average, target companies feature slower revenue, earnings growth than the market, suffer negative share price momentum, and have weaker-than-average corporate governance Refer to Pages 42-45 of Reading 28 for further
information on activist investing
Other strategies active portfolio managers employ to beat the benchmark index include statistical arbitrage and event-driven strategies Both strategies extensively use quantitative data and are implemented in a systematic, rule-based way but can also incorporate management judgment
3.5.1) Strategies Based on Statistical Arbitrage and Market Microstructure
Statistical arbitrage strategies use statistical and technical analysis to exploit pricing anomalies
Data commonly used include:
• Stock price
• Dividend
• Trading volume
• Limit order book Analytical tools used include:
• Traditional technical analysis
• Sophisticated time-series analysis and econometric models
• Machine-learning techniques
Practice: Example 6, CFA Curriculum, Volume 4, Reading 28
Trang 8Portfolio managers take advantage of mean reversion in
share prices or opportunities created by market
microstructure issues
A Statistical Arbitrage Strategy: Pairs Trading
Statistical techniques are used to identify two securities
which are highly correlated with each other
Pairs trading takes a bet on the mean reversion in prices:
When the price relationship between the two securities
deviates from the long-term average and the deviation
is temporary, managers go long the underperforming
stock and short the outperforming stock As prices
converge to the long-term average, the manager closes
the trade securing a profit
Risk of pairs trading: The price divergence is not
temporary but due to structural reasons
Investors use a stop-loss rule for the risk management of
such trades
Identifying stocks pairs can be done either by using a
quantitative approach and creating models of stock
prices or by using a fundamental approach to judge the
two stocks whose prices should move together for
quantitative reasons
Many market microstructure-based arbitrage strategies
in the US take advantage of the NYSE Trade and Quote
database and often involve extensive analysis of the
limit order book Investors with analytical tools and
capabilities for high-frequency trades are in a position to
profit from such very short-term price discrepancies
3.5.2) Event Driven Strategies
Strategies exploit market inefficiencies related to corporate events such as mergers and acquisitions, earnings or restructuring announcements, share buybacks, special dividends, and spinoffs
Risk arbitrage associated with merger and acquisition (M&A) activity is the most common example of an event-driven strategy Two types of compensation for M&A transactions:
1) Cash-only transaction:
• Acquirer purchases shares of target at a proposed price
• Stock price of target < offer price until transaction completion
• Difference in prices creates profit opportunity for acquirer
2) Share-for-share exchange transaction:
• Acquirer uses own shares to purchase target company shares at an exchange ratio
• A risk-arbitrageur purchases target shares and short-sells acquirer shares using exchange ratio
• Shares of the target are used to cover acquirer’s short positions when acquisition is closed
Considerations for a risk-arbitrageur:
• Estimating the risk of a deal failing is challenging
• Deal duration must be considered to accurately estimate deal premium and decided which deal to participate in
4 Creating a Fundamental Active Investment Strategy
4.1 The Fundamental Active Investment Process
Goal of active management is to outperform a
benchmark on a risk-adjusted basis net of fees and
transaction costs
Steps followed by fundamental investors in the process:
1 Define the investment universe and market
opportunity or investment thesis, which is the
opportunity to earn an active return based on the
investment mandate
• Investment universe is determined by the
mandate agreed on by the manager and
client
• Mandate defines the market segments,
countries and regions in which value will be
sought
• Investment thesis: Investors need to know what
is the opportunity and why is it there
o The ‘why’ can be determined by
understanding economic, financial, behavioral or other rationale for a strategy’s profitability in the future
2 Prescreen the investment universe to identify manageable securities for further analysis:
• May be done using qualitative and quantitative criteria
• Can be associated with a particular investment style
• For example, value style managers may rule out stocks with high P/E ratios and high debt-to-equity ratios
Practice: Example 7, CFA
Curriculum, Volume 4, Reading 28
Trang 93 Identify company and business of screened stocks
by performing:
• industry and competitive analysis and
• analyzing financial reports
4 Forecast company performance often done in
terms of earnings or cash flows
5 Convert forecasts to valuations and identify ex
ante profitable investments
6 Construct a portfolio of identified investment with
the desired risk profile
• Stocks with high potential versus benchmark
are overweighed
• Stock with low potential versus benchmark are
underweighted, not held at all, or shorted
7 Rebalance the portfolio using buy and sell
disciplines
• Ensure desired risk exposures and investment
mandate are maintained
• A stock sell discipline will enable profiting from
a successful investment and timely exit from an
unsuccessful investment
In fundamental analysis, target stock price = fair market
value of stock
If actual stock price > target price:
• stock is overvalued
• upside potential is limited
• potential for downside risk exists
• managers should sell stock
Target price may be revised with the arrival of new
information Stock may also be sold if target price is
adjusted to be lower than current market price
Note:
• Analyst must consider his/her behavioral biases
when a stock continues to be held despite
deteriorating fundamentals
• Stop-loss trigger point: Sets maximum loss for asset
and is intended to limit behavioral biases by stock
to be sold when the stock price touches this
point
4.2 Pitfalls in Fundamental Investing
Common pitfalls include behavioral biases, the value
trap and the growth trap
4.2.1.) Behavioral Bias
Fundamental, discretionary investing and stock selection
are subject to behavioral bias as they depend on
subjective judgments by portfolio managers in research and analysis
CFA Program Curriculum divides biases into two groups
as follows:
1 Cognitive errors - basic statistical, information-processing, or memory errors
2 Emotional biases – arise spontaneously as a result of attitudes and feelings
Both biases cause decisions to deviate from rational decisions of traditional finance
4.2.1.1) Confirmation Bias
• A cognitive error
• Analysts look for information confirming their existing beliefs on favored companies and ignores/undervalues contradictory information
Also known as stock love bias
• known as selection bias - results in selective exposure, perception and retention
• Consequence of bias: poorly diversified portfolio, excessive risk exposure, and holdings
in poorly performing securities
• Risk of bias is reduced by actively seeking opinion of others considering a range of information sources
4.2.1.2) Illusion of Control
• A cognitive error
• Investors overestimate their ability to select
stocks and influence outcomes
• Consequences of bias: Excessive trading and/or heavy weighting in selected stocks
• Bias can be reduced by seeking contrary viewpoints and setting and enforcing proper trading and diversification rules
4.2.1.3.) Availability Bias
• Information-processing bias falling in the cognitive error category
• Probability of outcome is estimated based on information availability and how easily outcome are recalled
• Easily recalled outcomes are perceived as more likely than those harder to recall or understand
• Consequence of bias: May reduce investment opportunity set and result in insufficient
diversification as manager opts for selective stocks which are familiar
• Bias can be reduced by conducting a disciplined portfolio analysis with a long-term focus which will eliminate any short-term emphasis caused by this bias
Practice: Example 8, CFA
Curriculum, Volume 4, Reading 28
Trang 104.2.1.4.) Loss Aversion Bias
• Emotional bias
• Investors prefer avoiding losses over achieving
gains
• Utility derived from a gain is lower than the
utility given up in a loss
• Consequences of bias: Unbalanced portfolios
are held: poorly performing positions are kept
in home of recovery and successful
investments are sold early to avoid risk
• Bias can be avoided by a disciplined trading
strategy with a stop-loss rule
4.2.1.5) Overconfidence Bias
• Emotional bias
• Investors demonstrated a high level of faith in
their judgement, reasoning and/or cognitive
abilities
• Individuals may overestimate knowledge,
abilities and access to information
• Consequences of bias: Overestimation of
expected results and underestimation of risks
• Bias can be avoided by regular review of
actual investment records and seeking
constructive feedback from other
professionals
4.2.1.6) Regret Aversion Bias
• Emotional bias
• Investors avoid pain of regret associated with
making poor decisions
• Consequence of bias: Investors may refrain
from decision-making, hold on to positions for a
long time and miss out on profitable
opportunities
• Bias can be avoided by using a carefully
defined portfolio review process – review and
justify existing positions and provide evidence
for a decision to avoid certain stocks
4.2.2) Value and Growth Traps
Value- and growth-oriented investors face risks known as
traps
4.2.2.1.) The Value Trap
A stock that appears to be attractively value with a low P/E multiple and/or low book value or price-to-cash flow multiples but is overpriced given worsening future prospects
A value trap appears to be an attractive investment and so investors should conduct research in a company before investment so that they understand reasons for attractive valuation
An investor is likely to fall into a value trap if a company does not have any catalysts available to trigger a reevaluation of its prospects In this case, a stock is less likely to adjust to fair value
4.2.2.2) The Growth Trap
Possible growth traps:
• Growth investors invest in stocks with the expectation of above-average earnings growth in the future If expectations are not met, company stock will underperform
• An overpriced stock is purchased, and the investee company may deliver above-average earnings and/or cash flow growth, in line with expectations However, share price does not move higher due to its high starting level
Investors are willing to pay a high price for growth stocks
as they believe earnings are sustainable and earnings are likely to grow fast in the future
Risks of value trap investing:
• Company’s superior market position may not
be sustainable due to competitive forces
• Earnings may experience an initial accelerated increase only to undergo a marked slowdown subsequently
5 Creating a Quantitative Active Investment Strategy
5.1 Creating a Quantitative Investment Process
Quantitative/systematic/rules-based investing generally
has a structured and well-defined process
The process starts with a belief or hypothesis and relies
on data from a wide range of sources, data science
and management to deal with missing values and
outliers, and quantitative models to test the hypothesis
5.1.1) Defining the Market Opportunity (Investment Thesis)
Like fundamental active investors, quantitative active investors believe that market is not efficient Fund managers use publicly available information to predict future stock returns