Active Equity Investing

Active equity investing is a strategy that involves making investment decisions based on a variety of ideas about profitable investment opportunities. These strategies can be divided into two broad categories: fundamental and quantitative. In the world of finance, these strategies are used by portfolio managers and investors to make informed decisions about where to allocate their funds for maximum returns.

In the field of investment analysis, there are several approaches that analysts use to make informed decisions. These approaches can be broadly categorized into bottom-up fundamental analysis , top-down fundamental analysis , and quantitative analysis . Each of these methods uses different types of information and has its unique advantages and disadvantages.

Fundamental Approach

The fundamental approach is based on research into companies, sectors, or markets and involves the application of analyst discretion and judgment. This approach often uses valuation models, quantitative screening tools, and statistical techniques such as regression analysis. The fundamental research forms the basis of this approach and often begins with the analysis of a company’s financial statements. For instance, an analyst might look at Apple Inc.’s financial statements to understand its current and past profitability, financial position, and cash flows. Based on this valuation and other factors, such as market trends and economic indicators, the portfolio manager may conclude that the stock should be bought or sold. Fundamental strategies may have various starting points, some start at a top or macro level, these are called top-down strategies. Other strategies, often referred to as bottom-up strategies, rely on individual stock analysis to identify areas of opportunity.

Bottom-up Fundamental Analysis

Bottom-up fundamental analysis is a method that focuses on the analysis of individual companies. Analysts who use this approach start their research at the company level and work their way up to the industry and economy.

• Analysts using this approach might look at a company’s financial statements and disclosures, similar to how an analyst at Goldman Sachs might examine Apple Inc.’s quarterly earnings report.
• They assess attributes such as profitability, leverage, and absolute or peer-relative valuation. For instance, they might compare Apple’s profit margin to that of its competitors like Samsung and Huawei.
• These metrics are then compared to their historical values to identify trends. For example, if Apple’s profit margin has been increasing over the past few quarters, it could indicate a positive trend.
• Analysts also scrutinize characteristics such as the company’s management competence, its future prospects, and the competitive position of its product lines. They might look at how Tim Cook has been leading Apple and the potential of its new product lines like Apple Watch.
• They focus on the more recent financial statements, notes to the financial statements and assumptions in the accounts, and management discussion and analysis disclosures.
• They often consider corporate governance and wider environmental, social, and governance (ESG) characteristics. For example, they might look at Apple’s sustainability initiatives and its board diversity.

Top-down Fundamental Analysis

Top-down fundamental analysis, on the other hand, starts with the broader economy and works its way down to the industry and individual company.

• Analysts using this approach might first look at macroeconomic indicators such as GDP growth rate, inflation rate, and unemployment rate. For instance, they might look at the economic growth in the US before deciding to invest in US-based companies.
• Some of the data used by fundamental managers can be quantified, while other items, such as management quality and reputation, cannot. For example, while GDP growth rate can be quantified, the reputation of a company’s management team is subjective and cannot be quantified.

Quantitative Analysis

The quantitative approach is based on quantitative models of security returns that are applied systematically with limited involvement of human judgment or discretion. This approach involves analyst judgment at the design stage, but they largely replace the ongoing reliance on human judgment and discretion with systematic processes that are often dependent on computer programming for execution. These systematic processes search for security and market characteristics and patterns (“factors”) that have predictive power in order to identify securities or trades that will earn superior investment returns. Factors that might be considered include valuation, size, profitability, financial strength, market sentiment, industry membership, and price-related attributes. For example, a quantitative model might analyze the historical data of the S&P 500 to predict future expected returns of securities or baskets of securities. From a quantitative perspective, investment success depends not on individual company insights but on model quality.

Quantitative analysis uses mathematical and statistical methods to evaluate investment or financial decision-making.

• Quantitative approaches often use large amounts of historical data from companies’ financial reports and other information, such as return data, but process those data in a systematic rather than a judgmental way. For example, a quantitative analyst might use a machine learning algorithm to analyze the historical stock prices of Apple.
• Judgment is used in model building, particularly in deciding which variables and signals are relevant. For instance, the analyst might decide to include variables like earnings per share and price-to-earnings ratio in the model.
• Quantitative approaches use historical stock data and statistical techniques to identify variables that may have a statistically significant relationship with stock returns; then these relationships are used to predict individual security returns.
• Unlike the fundamental approach, the quantitative approach does not normally consider information or characteristics that cannot be quantified.
• To minimize survivorship and look-ahead biases, historical data used in quantitative research should include stocks that are no longer listed, and accounting data used should be the original, un-restated numbers that were available to the market at that point in time.

Differences in the Focus of the Analysis

In the world of investment, there are different types of investors, each with their unique approach to analyzing and selecting stocks: Fundamental Investors and Quantitative Investors .

Fundamental Investors

Fundamental investors are those who base their investment decisions on the intrinsic value of stocks. They typically concentrate on a relatively small group of stocks. For instance, Warren Buffet, a renowned fundamental investor, focuses on a select few companies like Apple, Bank of America, and Coca-Cola.

These investors perform in-depth analysis on each of these stocks, examining factors such as the company’s financial health, industry position, and market competition. This approach gives them a deeper understanding of individual companies’ businesses. As a result, they tend to take larger positions in their selected stocks, often holding these investments for a long period.

Quantitative Investors

Quantitative investors, on the other hand, do not focus on individual stocks. Instead, they usually focus on factors across a potentially very large group of stocks. For example, a quantitative investor might analyze data from hundreds or even thousands of stocks to identify patterns or trends.

They tend to focus their analysis on a selection of factors, such as price momentum, earnings growth, or market volatility. They spread their selected factor bets across a substantially larger group of holdings, diversifying their portfolio to mitigate risk.

Comparison

While fundamental investors have an edge in understanding individual companies, quantitative investors have a broader view of the market. The focus of fundamental investors is depth, delving deep into the details of a few select companies. In contrast, the focus of quantitative investors is breadth, analyzing a wide range of stocks based on selected factors.

Distinct Approaches to Data Analysis: A Comparison between Forecasting Fundamentals and Pattern Recognition

Fundamental Analysis

Fundamental analysis focuses on forecasting future prospects of a company, including its future earnings and cash flows. For instance, a fundamental analyst might assess the financial health of Apple Inc. by looking at its revenue, earnings, future growth, return on equity, profit margins, and other data to determine the company’s underlying value and potential for future growth.

Fundamental investors use their judgment and in-depth analysis to formulate a view of the company’s outlook and identify catalysts for future growth. They rely on their knowledge, experience, and ability to predict future conditions in a company to make investment decisions. The fundamental approach aims at forecasting forward parameters to make investment decisions.

Many fundamental investors use a quantitative component in their investment process, such as a quantitative screen or a commercial quantitative risk model produced by companies like Axioma, MSCI, Northfield, and Bloomberg.

Quantitative Approach

The quantitative approach, on the other hand, aims to predict future returns using conclusions derived from analyzing historical data and patterns. For example, a quantitative analyst might use statistical models to predict the future performance of Microsoft’s stock based on historical data.

Quantitative investors construct models by back-testing on historical data, using what is known about or has been reported by a company, including future earnings estimates that have been published by analysts, to search for the best company characteristics for stock selection.

Once a model based on historical data has been finalized, it is applied to the latest available data to determine investment decisions. While the process is distinct from the fundamental approach, the active return and risk profiles of many fundamentals managers have been explained or replicated using well-known quantitative factors.

Differences in Portfolio Construction: Judgment vs. Optimization

Portfolio construction is a critical process that involves selecting the right mix of assets to achieve a specific investment objective. There are two primary approaches to portfolio construction: judgment-based (often used by fundamental investors) and optimization-based (commonly used in quantitative analysis). These two approaches differ significantly in their methodology, risk perception, and portfolio management strategies.

Fundamental Investors

Fundamental investors are those who base their investment decisions on the intrinsic value of a company. They conduct extensive research on individual companies, analyzing their financial statements, industry position, and market trends. This leads to a list of high-conviction stocks that they believe are undervalued and have strong growth potential.

• For instance, a fundamental investor might analyze Apple Inc.’s financial health, market position in the tech industry, and future growth prospects before deciding to invest in its stocks.
• The risk perceived by fundamental investors is primarily at the company level. This includes the risk of inaccurate assessment of the company’s fair value, the business’s performance differing from the analyst’s expectations, or the market failing to recognize the identified reason for under- or overvaluation.
• The construction of a fundamental portfolio often depends on judgment, where the absolute or index-relative sizes of positions in stocks, sectors, or countries are based on the manager’s conviction of his or her forecasts. For example, if a portfolio manager has a strong conviction about the growth prospects of the tech sector, they might allocate a larger portion of the portfolio to tech stocks.
• However, the portfolio must still comply with the risk parameters set out in the investment agreements with clients or in the fund prospectus. Managers using a fundamental approach usually monitor the portfolio’s holdings continuously and may increase, decrease, or eliminate positions at any time based on their judgment and market conditions.

Quantitative Analysis

Quantitative analysis, on the other hand, relies on mathematical and statistical models to make investment decisions. The risk in quantitative analysis is that factor returns will not perform as expected.

Risks and Portfolio Management

Unlike fundamental investors, quantitative analysts invest in baskets of stocks, meaning the risks lie at the portfolio level rather than at the level of specific stocks. For example, a quantitative analyst might use a factor-based model to select a diversified portfolio of stocks with high momentum, low volatility, and strong value characteristics.

Portfolio Construction

Construction of a quantitative portfolio is generally done using a portfolio optimizer, which controls for risk at the portfolio level in arriving at individual stock weights. Portfolios managed using a quantitative approach are usually rebalanced at regular intervals, such as monthly or quarterly.

Systematic Approach

At each interval, the program or algorithm, using pre-determined rules, automatically selects positions to be sold, reduced, added, or increased. This systematic approach reduces the influence of human bias and emotion in investment decisions, potentially leading to more consistent performance over time.

Practice Questions

Question 1: A portfolio manager is considering two different strategies for active equity investing. The first strategy involves detailed research into companies, sectors, or markets and the application of analyst discretion and judgment. This strategy often uses valuation models, quantitative screening tools, and statistical techniques such as regression analysis. The second strategy is based on quantitative models of security returns that are applied systematically with limited involvement of human judgment or discretion. This strategy involves analyst judgment at the design stage, but they largely replace the ongoing reliance on human judgment and discretion with systematic processes. Which of the following best describes these two strategies?

1. The first strategy is a quantitative approach, and the second strategy is a fundamental approach.
2. The first strategy is a fundamental approach, and the second strategy is a quantitative approach.
3. Both strategies are examples of a fundamental approach.

Answer: Choice B is correct.

The first strategy described involves detailed research into companies, sectors, or markets and the application of analyst discretion and judgment. This strategy often uses valuation models, quantitative screening tools, and statistical techniques such as regression analysis. This is a description of a fundamental approach to investing. Fundamental analysis involves assessing a company’s intrinsic value by examining related economic, financial, and other qualitative and quantitative factors. It includes analyzing financial statements, industry position, and market competition, among other things. The goal of fundamental analysis is to produce a value that an investor can compare with the security’s current price, with the aim of figuring out what sort of position to take with that security (underpriced = buy, overpriced = sell or short).

Choice A is incorrect. The first strategy is not a quantitative approach. A quantitative approach to investing seeks to understand behavior by using complex mathematical and statistical modeling, measurement, and research. While the first strategy does use some quantitative tools, it is fundamentally based on the analyst’s discretion and judgment, making it a fundamental approach.

Choice C is incorrect. Both strategies are not examples of a fundamental approach. The second strategy is based on quantitative models of security returns that are applied systematically with limited involvement of human judgment or discretion. This strategy involves analyst judgment at the design stage, but they largely replace the ongoing reliance on human judgment and discretion with systematic processes. This is a description of a quantitative approach to investing.

Question 2: A portfolio manager is using a strategy that involves the analysis of a company’s financial statements to understand the company’s current and past profitability, financial position, and cash flows. Based on this valuation and other factors, the portfolio manager may conclude that the stock should be bought or sold. This strategy may start at a top or macro level, or it may rely on individual stock analysis to identify areas of opportunity. What is this strategy most likely called?

1. Top-down strategy
2. Bottom-up strategy
3. Fundamental approach

Answer: Choice C is correct.

This strategy is most likely called the Fundamental Approach. Fundamental analysis involves the examination of a company’s financial statements, the competitive environment, and the health of the overall economy. It seeks to identify the intrinsic value of an investment, with the goal of finding long-term investment opportunities. The fundamental approach can be applied at both the macro level (analyzing the overall economy and industry conditions) and the micro level (analyzing individual companies). The portfolio manager in the question is using this approach, as they are analyzing the company’s financial statements to understand its current and past profitability, financial position, and cash flows. Based on this analysis, they are making decisions about whether to buy or sell the stock. This is a clear example of the fundamental approach to investment analysis and portfolio management.

Choice A is incorrect. A top-down strategy starts with an analysis of the overall economy, then moves down to the industry level, and finally to the company level. While the portfolio manager in the question may be using some elements of a top-down strategy, the focus on individual company analysis suggests that they are using a fundamental approach.

Choice B is incorrect. A bottom-up strategy focuses on the analysis of individual companies, without much regard for macroeconomic conditions or industry trends. While the portfolio manager in the question is certainly analyzing individual companies, they are also considering other factors, such as the company’s financial position and cash flows, which suggests a more comprehensive, fundamental approach.

Glossary

• Quantitative Analysis: A method of understanding behavior by using mathematical and statistical modeling, measurement, and research to evaluate investments.
• Portfolio Optimizer: A tool that uses advanced mathematical and statistical techniques to determine the optimal asset allocation within an investment portfolio.
• High-Conviction Stocks: Stocks identified through extensive research that are believed by investors or fund managers to significantly outperform the market.
• Factor Returns: The returns attributable to specific drivers of risk and return in financial markets, such as size, value, and momentum.
• Quantitative Approach: An investment strategy relying on quantitative models to systematically apply conclusions from historical data analysis, minimizing human judgment.
• Survivorship Bias: A statistical bias that occurs by focusing only on surviving examples, thus overlooking those that have failed, potentially leading to false conclusions.
• Look-ahead Bias: A bias that happens when a model erroneously uses information not available during the analyzed period, leading to inaccurate predictions.
• Intrinsic Value: The valuation of a company based on both tangible and intangible aspects as determined through fundamental analysis.
• Back-testing: The practice of testing a trading or investment strategy using historical data to evaluate its efficacy before applying it in real market conditions.
• Active Return: The difference in return between an investment and an appropriate benchmark index, representing the value added (or lost) by active management.

Portfolio Management Pathway Volume 1: Learning Module 2: Active Equity Investing: Strategies; LOS 2(a): Compare fundamental and quantitative approaches to active management