Active Management

Active management is a strategy that involves making investment decisions in an attempt to outperform a specific benchmark index. Fund managers often employ this strategy, using their skills and proprietary data to add value at different stages of the investment process. This could be through in-depth security analysis, valuation, or industry/sector allocation insight.

Steps in Active Management

• Defining the Investment Universe: This involves identifying the market opportunity in line with the investment mandate. Understanding the market opportunity is crucial for investors seeking to hold a diversified and well-constructed portfolio. The market opportunity refers to the potential for earning positive active returns in a specific market. The investment thesis answers the question of what the opportunity is and why it exists.
• Prescreening the Investment Universe: This step involves narrowing down the investment universe to a manageable set of securities for further analysis.
• Understanding the Industry and Business: This involves performing industry and competitive analysis and analysis of financial reports.
• Forecasting Company Performance: This is usually done in terms of cash flows or earnings.
• Converting Forecasts to Valuations: This involves identifying ex-ante profitable investments.
• Constructing a Portfolio: This involves creating a portfolio of these investments with the desired risk profile.
• Rebalancing the Portfolio: This involves adjusting the portfolio with buy and sell disciplines.

Investment Thesis and Prescreening

An investment thesis is a strategic proposition that connects investment decisions to the investor’s goals. It outlines the key characteristics that could make an investment profitable. For instance, an investor might be interested in companies with a strong market presence and a stable financial performance. To streamline the investment process, investors often use prescreening methods. These methods use quantitative and qualitative criteria to filter out less promising investment opportunities. For example, a value investor might exclude companies with high Price-to-Earnings (P/E) ratios and high debt-to-equity ratios, while a growth investor might exclude companies that do not show significant historical or projected Earnings Per Share (EPS) growth.

Portfolio Construction

Once the prescreening process is complete, the investor constructs a portfolio. This involves selecting stocks with high potential for profit and giving them more weight than the benchmark. Stocks that are expected to underperform the benchmark are given less weight, not included at all, or shorted. The portfolio manager must decide whether to take active exposures to specific industry groups or economic sectors or to remain sector-neutral relative to the benchmark. For example, if the manager believes that the technology sector will outperform, they might overweight their portfolio with tech stocks.

Portfolio Rebalancing and Stock Sell Discipline

Regular portfolio rebalancing is crucial to maintain the investment mandate and desired risk exposures. A disciplined approach to selling stocks is also necessary. This allows the portfolio to profit from successful investments and exit unsuccessful ones at the right time. For instance, if a stock’s price surpasses its target price, it may be reclassified from undervalued to overvalued, prompting the manager to sell. However, if the stock’s price falls for reasons that are not well understood, the manager may decide to sell the stock if it reaches a pre-defined stop-loss trigger point.

Pitfalls in Fundamental Investing

Pitfalls in fundamental investing include behavioral biases, the value trap, and the growth trap.

Behavioral Biases in Fundamental Investing

Behavioral biases significantly influence fundamental, discretionary investing, especially in stock selection. This process heavily depends on portfolio managers’ subjective judgments, derived from their research and analysis. Despite the potential for deeper insight, human judgment can often be irrational and prone to biases.

The CFA Program curriculum readings on behavioral finance classify behavioral biases into two primary categories: cognitive errors and emotional biases. Cognitive errors are basic statistical, information-processing, or memory errors causing a decision to deviate from traditional finance’s rational decisions. Conversely, emotional biases are spontaneous, stemming from attitudes and feelings, causing a decision to deviate from traditional finance’s rational decisions.

Several biases are pertinent to active fundamental equity management. Understanding these biases can assist portfolio managers in making more informed and rational decisions, thereby enhancing their investment strategies and outcomes.

Confirmation Bias

Confirmation bias, also known as “stock love bias,” is a cognitive error in which investors tend to seek information that supports their existing beliefs about favored companies while disregarding contradicting information. This can lead to a poorly diversified portfolio and excessive risk exposure. For instance, an investor might ignore negative news about Apple Inc. because they are heavily invested in it. To mitigate this, it is recommended to actively seek diverse opinions and information sources.

Illusion of Control Bias

The illusion of control bias is a belief that one can control or influence outcomes, often seen in active equity management. For example, a skilled investor might believe they can outperform the market by picking the right stocks. This bias, defined by Langer (1983), can lead to excessive trading or heavy weighting on a few stocks. To avoid this, investors should seek contrary viewpoints and enforce proper trading and portfolio diversification rules.

Availability Bias

Availability bias is a cognitive error where individuals estimate the probability of an outcome based on how easily it can be recalled. For instance, a portfolio manager might prefer investing in Apple or Microsoft because of their familiarity, thereby limiting the investment opportunity set and leading to insufficient diversification. It is advisable to adopt a long-term investment strategy and conduct disciplined portfolio analysis to counteract this bias.

Loss Aversion

Loss aversion is an emotional bias where investors prefer avoiding losses over achieving gains. For example, an investor might hold onto a poorly performing stock like Kodak in hopes of recovery while selling a successful investment like Amazon prematurely to avoid risk. To avoid this, investors should adopt a disciplined trading strategy with firmly established stop-loss rules.

Overconfidence Bias

Overconfidence bias is an emotional bias that can lead investors to overestimate their own abilities and knowledge. For instance, a trader might attribute their successful trades to their skill, ignoring the role of market trends or luck. This can lead to an underestimation of risks and an overestimation of expected returns. Regular review of actual investment records and seeking feedback from other professionals can help mitigate this bias.

Regret Aversion Bias

Regret aversion bias is another emotional bias that can cause investors to avoid making decisions for fear of regretting poor outcomes. For example, an investor might hold onto a losing stock for too long, missing out on other profitable opportunities. A well-defined portfolio review process can help in mitigating this bias.

Value Trap

A value trap refers to a situation where a stock appears to be attractively valued, often indicated by a low P/E multiple, low price-to-book value, or low price-to-cash-flow multiples. This attractive valuation is typically due to a significant price drop. However, despite the low price, the stock may still be overpriced, considering its deteriorating future prospects.

For example, consider a company like Kodak that was trading at a low price relative to its earnings or book value. This could have been a sign that the company or its sector was facing worsening future prospects. This could mean that the stock prices may remain low for a prolonged period or even decline further.

Value traps can be so appealing that investors may find it hard to comprehend why the stock is underperforming. Therefore, it is crucial for value investors to conduct comprehensive research before investing in any company that seems to be cheap. This will help them understand the reasons behind the seemingly attractive valuation.

Stock prices usually require catalysts or a change in perceptions to increase. If a company lacks any catalysts to trigger a reevaluation of its prospects, the chances of the stock price adjusting to reflect its fair value are reduced. In such a scenario, even though the stock may seem like an attractive investment due to its low multiple, it could lead the investor into a value trap.

The Growth Trap

The Growth Trap refers to a predicament often faced by investors in growth stocks. This situation arises when the share price of a company fails to appreciate as anticipated due to various factors. For instance, consider the case of Tesla Inc., where despite robust earnings growth, the share price may not rise as expected due to high initial valuation.

Investors often pay high multiples for growth stocks like Amazon, believing that the current earnings are sustainable and will grow rapidly in the future. However, these assumptions may not always hold true. For instance, a company’s superior market position may be temporary and may only last until competitors like Walmart respond. Factors specific to the industry often dictate the rate of growth.

Similar to the value trap in value stocks, the potential for a growth trap should be considered when investing in perceived growth stocks. Investors must meticulously evaluate the company’s earnings potential and market position before investing.

Practice Questions

Question 1: An investment manager is preparing to construct a portfolio for a new client. The client has specified that the performance benchmark for this portfolio will be the Hang Seng Index of Hong Kong. The manager is now defining the investment universe for this portfolio. Which of the following statements best describes the investment universe that the manager will likely consider for this portfolio?

1. The investment universe will be restricted to the 50 stocks in the Hang Seng Index.
2. The investment universe will include all stocks that trade on the Hong Kong Stock Exchange.
3. The investment universe will primarily include the 50 stocks in the Hang Seng Index, but may also include non-index stocks that trade on the same exchange or whose business activities significantly relate to this region.

Answer: Choice C is correct.

The investment universe that the manager will likely consider for this portfolio will primarily include the 50 stocks in the Hang Seng Index, but may also include non-index stocks that trade on the same exchange or whose business activities significantly relate to this region. The investment universe is the set of assets that an investment manager considers when constructing a portfolio. It is defined based on the investment objectives and constraints of the client. In this case, the client has specified the Hang Seng Index as the performance benchmark. Therefore, the investment universe will primarily consist of the stocks included in this index. However, the manager may also consider other stocks that trade on the Hong Kong Stock Exchange or that have significant business activities in the region. This is because these stocks may offer opportunities for diversification, risk management, or enhanced returns. The manager’s goal is to construct a portfolio that meets the client’s objectives while managing risk effectively.

Choice A is incorrect. While the Hang Seng Index is the performance benchmark, restricting the investment universe to only the 50 stocks in the index may limit the manager’s ability to manage risk and achieve the client’s investment objectives.

Choice B is incorrect. Including all stocks that trade on the Hong Kong Stock Exchange in the investment universe may be too broad. The manager needs to consider the client’s investment objectives and constraints, and not all stocks on the exchange may be suitable for the client’s portfolio.

Question 2: A fund manager is following an active management strategy for a portfolio. As part of this strategy, the manager is trying to understand the market opportunity for the portfolio. Which of the following best describes the basic question that the manager is trying to answer to understand the market opportunity?

1. What is the current market price of the securities in the portfolio?
2. What is the opportunity and why is it there?
3. What is the historical performance of the securities in the portfolio?

Answer: Choice B is correct.

The basic question that a fund manager following an active management strategy is trying to answer to understand the market opportunity is “What is the opportunity and why is it there?” Active management involves making investment decisions based on research, analysis, and professional judgment. The goal is to outperform a specific benchmark index. To do this, the manager needs to identify opportunities in the market where they believe they can achieve higher returns. This involves understanding what the opportunity is and why it exists. The “why” could be due to a variety of factors, such as market inefficiencies, mispricing of securities, or changes in economic or industry conditions. Understanding the opportunity and its cause can help the manager make informed decisions about whether to invest in a particular security or sector, and how to allocate the portfolio’s assets to maximize returns.

Choice A is incorrect. While knowing the current market price of the securities in the portfolio is important, it does not directly answer the question of what the market opportunity is. The market price of a security is just one factor that a manager would consider when assessing an investment opportunity.

Choice C is incorrect. The historical performance of the securities in the portfolio can provide useful information, but it does not directly answer the question of what the market opportunity is. Past performance is not necessarily indicative of future results, and a manager following an active strategy would be more focused on future prospects and opportunities rather than past performance.

Glossary

• Investment Thesis: A strategic proposition that connects investment decisions to the investor’s goals.
• Prescreening: A process that uses quantitative and qualitative criteria to filter out less promising investment opportunities.
• Portfolio Rebalancing: The process of realigning the weights of a portfolio’s assets to maintain the desired risk exposures.
• Stock Sell Discipline: A strategy that determines when to sell a stock.
• Cognitive errors: Basic statistical, information-processing, or memory errors causing a decision to deviate from traditional finance’s rational decisions.
• Emotional biases: Spontaneous biases stemming from attitudes and feelings, causing a decision to deviate from traditional finance’s rational decisions.
• Confirmation Bias: A cognitive bias that involves favoring information that confirms existing beliefs or values.
• Illusion of Control Bias: A tendency for individuals to believe they can control or at least influence outcomes that they clearly cannot.
• Availability Bias: A cognitive error where individuals estimate the probability of an outcome based on how easily it can be recalled.
• Loss Aversion: An emotional bias where investors prefer avoiding losses over achieving gains.
• Overconfidence Bias: An emotional bias that leads to an overestimation of one’s abilities and knowledge.
• Regret Aversion Bias: An emotional bias that causes avoidance of decision-making due to fear of regret.
• Value Trap: A situation where a stock appears to be attractively valued but may still be overpriced considering its deteriorating future prospects.
• P/E Multiple: The ratio of a company’s current share price to its per-share earnings.
• Price-to-Book-Value: A financial ratio used to compare a company’s current market price to its book value.
• price-to-cash-flow: A measure of the market’s expectations of a firm’s future financial health.
• Growth Trap: A situation where the share price of a growth stock does not appreciate as expected due to various factors.
• Value Trap: A situation where a stock appears to be cheap but is actually appropriately priced due to underlying problems in the company.

Portfolio Management Pathway Volume 1: Learning Module 2: Active Equity Investing: Strategies; LOS 2(i): Describe how fundamental active investment strategies are created