2019 CFA level 3 qbank reading 28 active equity investing strategy answers

It is most likely that: A Both manager A and manager B are following quantitative active equity approaches B Manager A is following a fundamental active equity approach and manager B is

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Question #1 of 27

Consider two equity portfolios with the same benchmark index composed of 943 constituents

Active equity manager A has constructed a portfolio of 45 high conviction ideas which are

continuously monitored to assess whether their weights in the portfolio remain appropriate

Active equity manager B has active bets on 550 stocks with automatic rebalancing conducted

on regular monthly intervals It is most likely that:

A) Both manager A and manager B are following quantitative active equity approaches

B) Manager A is following a fundamental active equity approach and manager B is

following a quantitative active equity approach

C) Manager A follows a quantitative active equity approach and manager B follows a

fundamental active equity approach

Explanation

A fundamental manager will likely have fewer holdings than a quantitative active equity

manager due to the intensive research conducted on individual companies carried out to

generate high conviction investment ideas This is in contrast to the quantitative manager

who will likely construct a broad portfolio of hundreds of securities in order to generate the

desired exposure to risk factors expected to generate returns based on historical data The

rebalancing process of a fundamental manager is likely to involve continuous monitoring of

positions for changes in the weights of the portfolio, in contrast to the quantitative manager

who will have a more formal, regular automatic rebalancing strategy based on systematic

rules

(Study Session 14, Module 28.1, LOS 28.a)

Related Material

SchweserNotes - Book 4

Competitive positioning and environmental, social and governance (ESG) characteristics of a

company are most likely to be used as information sources for:

A) Neither quantitative nor fundamental active equity managers

B) Both quantitative and fundamental active equity managers

C) Fundamental active managers only

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Competitive positioning and environmental, social and governance (ESG) characteristics of a

company are data that are unlikely to be expressed numerically, and as such are unlikely to

be information used in a quantitative active equity approach Fundamental active equity

approaches focusing on bottom-up investing could consider such information as part of their

approach

(Study Session 14, Module 28.1, LOS 28.a)

The table below provides information on three stocks being considered for investment by a

bottom-up equity manager

Company Price

($)

12-Month Forward EPS

3-Year EPS Growth Forecast

Dividend ($) Industry Sector

Sector Average P/E

Which stock is most likely to be the best opportunity for investors that use a relative value

approach?

A) Stock S

B) Stock T

C) Stock U

Explanation

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Relative value investors look for low price multiples relative to the industry sector Stock S

has a PE of 5/0.25 = 20x which is equal to the industry average hence stock S is not a relative

value investment Stock T has a PE of 95/4.75 = 20x which is below the industry average of

25x hence making it potentially a relative value investment Stock U has a PE of 15/5.5 = 2.7x

which is considerably lower than the industry average of 12 This would suggest the Stock U

would be more appropriate for a deep value or distressed investing strategy than a relative

value strategy

(Study Session 14, Module 28.1, LOS 28.b)

A fundamental active equity investment manager screens the stocks in their universe in order

to create an equally weighted portfolio of securities that have a price-to-book ratio of less than

one Which of the following pitfalls of fundamental active investing is this manager most likely

to be subject to?

A) The value trap

B) Behavioural biases

C) The growth trap

Explanation

By screening the universe and allocating naively for stocks with a low price-to-book ratio the

manager will likely be investing in many securities that appear attractively valued, but are

correctly priced or even overpriced due to seriously deteriorating business conditions This is

referred to as the value trap

(Study Session 14, Module 28.3, LOS 28.g)

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An analyst is backtesting a quantitative investment process which investigates the relationship

between EPS announcements and subsequent month stock returns The analyst notes that one

speci c company in the universe frequently revises earnings – for example 2017 EPS was

initially announced in March 2018 as $2 when the market expected earnings of $2.10 These

2017 earnings were subsequently revised down to a loss of $1 per share in June 2018 due to

accounting fraud coming to light In order to avoid look ahead bias, when backtesting the

performance of the stock in April 2018, the manager should use an EPS value of:

A) $2

B) $2.10

C) -$1

Explanation

Look ahead bias occurs when using information that was unknown at the time to explain

stock returns In this case the market did not know in April of the earnings revision that was

to come later in the year, hence stock returns for April should be regressed against the EPS

that was known at the time, that being the $2 initially reported in March

(Study Session 14, Module 28.3, LOS 28.h)

An analyst who wishes to capture the most accurate and up-to-date style exposure of an

investment manager should:

A) Prefer to use returns-based analysis

B) Prefer to use holdings-based analysis

C) Be indi erent between using holdings based and returns based analyses

Explanation

An advantage of holdings-based analysis over returns-based analysis is that by looking at

current individual holdings of the fund, an analyst can get the most accurate and current

analysis of the manager's style exposure In comparison, returns-based analysis uses

historical regression hence will be more of a backward-looking view of the manager's historic

style exposures

(Study Session 14, Module 28.4, LOS 28.i)

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An analyst conducting a returns-based style analysis on an active equity fund constructs the

following monthly multivariate regression:

Where:

rt = the fund return in period t

LC = large cap style index

SC = small cap style index

εt = residual return not explained by style factors

The value added by the fund manager is closest to:

A) 0.5% plus the residual return, εt

B) The residual return, εt

C) 0.5%

Explanation

In a returns-based regression the slope coe cients are interpreted as the exposure to the

styles during the period, and the intercept term (0.005 or 0.5%) is generally interpreted as the

value added by the manager The residual term is random and unexplained and hence not

due to manager skill or the style factor exposures

(Study Session 14, Module 28.4, LOS 28.i)

= 0.005 + 0.7LC + 0.3SC +

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A quantitative active equity investment manager gathers the following data regarding

information coe cients (ICs) when backtesting the value, growth and size factors in their

investment universe:

Factor Pearson IC Spearman Rank IC

Value insigni cant signi cantly positive

Growth signi cantly positive signi cantly positive

Size signi cantly positive insigni cant

If the manager is concerned about biases caused by outliers in the data, they should most likely

conclude that the factors with strong predictive powers for subsequent returns are:

A) Value and Growth

B) Growth and Size

C) Value, Growth and Size

Explanation

The IC measures the correlation between factor scores and subsequent market returns The

Pearson IC measures the correlation of values which can be biased by the existence of

outliers in the data In order to avoid this bias, the Spearman Rank IC should be used which

looks at the correlation between the rank of factor scores and the rank of subsequent

returns The Spearman Rank IC suggests that there is predictive power for the factor when it

is signi cantly positive, i.e for the value and growth factors

(Study Session 14, Module 28.3, LOS 28.h)

Which of the following statements regarding activist equity investing is most accurate?

A) Activist investors tend to target companies that have lower than average revenue

growth with negative price momentum

B) Activist investors tend to target companies that have multi-class share structures

C) The assets under management of activist hedge funds decreased sharply during

the global nancial crisis of 2008/2009 and have since failed to recover to pre-crisis

l l

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Activist investors will target companies that are not being run e ciently These tend to be

companies that have slower than average revenue growth and negative price momentum A

multi-class share structure may hinder activist investors since this usually means that the

founder's shares have multiple votes per share The comment regarding the assets under

management of activist hedge funds is correct

(Study Session 14, Module 28.2, LOS 28.e)

Company A announces a cash-only purchase of Company B In order to pro t from this event, a

merger-arbitrage hedge fund manager would most likely:

A) Purchase the shares of Company B prior to the deal being announced

B) Purchase the share of Company B and short sell the shares of Company A after the

deal is announced

C) Purchase the shares of Company B after the deal is announced

Explanation

In a cash-only merger, the merger-arbitrage manager would purchase the shares of the

target company and earn a risk premium when the deal is closed This is done after the deal

is announced, since the price of the target company typically remains below the o ered price

until the transaction is completed and the manager can earn a pro t if and when the deal

closes There is no requirement to short sell the shares of the acquiring company in a

cash-only deal – this would be required if the transaction were a stock-for-stock acquisition

(Study Session 14, Module 28.3, LOS 28.f)

Which of the following statements is most accurate with respect to factor-mimicking portfolios?

A) Factor mimicking portfolios are usually constructed using long only portfolios

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B) Factor mimicking portfolios are commonly used in factor-tilting portfolios

C) Factor mimicking portfolios are relatively expensive to construct

Explanation

Factor mimicking portfolios are dollar neutral long/short portfolios that aim to generate a

unit exposure to a single factor As such they invest in very many positions without regard to

short selling constraints and transaction costs This can make them very expensive to

construct Factor tilting portfolios are not constructed using factor mimicking portfolios –

they are portfolios designed to track a benchmark with small tilts towards factors that the

manager expects to outperform

(Study Session 14, Module 28.2, LOS 28.d)

Which of the following statements regarding market-microstructure arbitrage strategies is least

accurate?

A) The typical time horizon of a trade is a few minutes

B) High-frequency trading techniques are a fundamental part of the strategy

C) The strategy analyses limit order books of exchanges to identify very short-term

mispricing opportunities

Explanation

Market microstructure arbitrage strategies involve extensive analysis of the limit order books

of trading venues to identify very short-term trading opportunities The time horizon of the

opportunities is usually a few milliseconds

(Study Session 14, Module 28.3, LOS 28.f)

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Company Price ($)

Which stock is most likely to be the best opportunity for investors that use a deep value

approach?

A) Stock U

B) Stock S

C) Stock T

Explanation

Deep value investors look for price multiples that are considerably lower than the industry

sector Stock S has a PE of 5/0.25 = 20x which is equal to the industry average hence stock S is

not a deep value investment Stock T has a PE of 95/4.75 = 20x which is below the industry

average of 25x hence making it potentially a relative value investment Stock U has a PE of

15/5.5 = 2.7x which is considerably lower than the industry average of 12 This would suggest

the Stock U would be more appropriate for a deep value or distressed investing strategy than

a relative value strategy

With regards to the potential pitfalls in investment strategies, which of the following statements

is likely to be most accurate?

A) A fundamental active equity investor who seeks information that agrees with their

existing beliefs is exhibiting availability bias

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B) Over tting is more likely to be a pitfall for a fundamental manager than a

quantitative active equity manager

C) The behavioural bias of overcon dence is more likely to be a pitfall for a

fundamental manager than a quantitative active equity manager

Explanation

Fundamental active equity managers use more subjective judgement than quantitative

managers, and hence are more likely to be subject to behavioural psychological biases that

can distort opinion Overcon dence, where a manager believes they have abilities beyond

those they actually possess, is an example of a behavioural bias Over tting is the process of

testing data until a pre-determined model is justi ed which is a pitfall of quantitative

approaches, not fundamental approaches A manager who seeks information that con rms

their existing beliefs is exhibiting con rmation bias, not availability bias

(Study Session 14, Module 28.3, LOS 28.g)

Company Price ($)

Which stock is most likely to be the best opportunity for investors that use GARP?

A) Stock T

B) Stock U

C) Stock S

Explanation

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Investors that use GARP will consider will invest in securities with low PE-to-growth (PEG)

ratios Stock S has a PE of 5/0.25 = 20x which is average for the industry, but growth is

expected to be signi cantly higher than the other stocks giving a PEG ratio of 20/20 = 1 The

PE ratio of stock T is 95/4.75 = 20x giving a PEG ratio of 20/3 = 6.6 which is much higher than

for Stock S, making the security less desirable to a GARP investor Stock U has negative

growth hence would not be appropriate for a growth investor

Consider the following three companies:

Company Listing Return on Assets Asset Turnover Cash Balance

Which of the above companies is most likely to o er an opportunity for activist investing?

A) LLB

B) JBC

C) SBD

Explanation

Activist investors take stakes in publicly listed companies since they often use public proxy

battles and open letters to other investors to push for their value enhancing changes This

rules out company LLB as a potential activist investment since it is unlisted An activist will

look for companies that are currently underperforming from a return on assets and assets

turnover perspective and seek to make changes to improve this performance and unlock

value Company SBD has low return on assets and asset turnover, with high cash balances

-this suggests the company could bene t from returning cash to shareholders and

repositioning the company to focus on higher productivity xed asset investments This

makes SBD A good candidate for activist investing Conversely, company JBC shows no

evidence of ine ciency since return on assets is high and other metrics are at average levels

(Study Session 14, Module 28.2, LOS 28.e)

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