Approaches to Active Management

Active Equity Investing

Active equity investing aims to outperform a passive benchmark. At a high level, active approaches can be categorized into two main types:

• Fundamental Approach.
• Quantitative Approach.

Fundamental Approach

The fundamental approach aims to generate alpha by picking individual securities. It involves portfolio managers assessing individual companies as investments, relying on their expertise to make decisions rather than rigid rules.

Fundamental analysis focuses on examining a company's financial statements, business strategies, and management teams. Metrics like net profit margin, asset turnover, and credit ratings are often considered, along with macroeconomic data.

Fundamental investors often have concentrated portfolios with a few significant holdings.

Quantitative Approach

The quantitative approach also aims for alpha but relies on clear, rule-based strategies, in contrast to the fundamental approach.

It's an objective method with specific guidelines. Quantitative analysis identifies predictive factors for security prices. When a strong factor-security price relationship is found, a systematic trading process is established based on these factors, leading to binary outcomes and predefined trades.

Data used in quantitative analysis can range from fundamental company data to technical indicators like moving averages or support/resistance levels.

Quantitative approaches often involve diversifying investments across a larger number of securities in a portfolio.

Question

A quantitative approach to equity investing is most appropriately described as:

1. Objective.
2. Subjective.
3. Intuitive.

Solution

The correct answer is A.

A quantitative approach is primarily objective. It involves using mathematical models, statistical analysis, and data to make investment decisions. This method aims to remove subjective judgment or personal biases and relies on historical data, financial ratios, and other quantitative factors to identify potential investments. The goal is to base investment decisions on empirical evidence and logical, repeatable processes.

B is incorrect. A subjective approach, on the other hand, relies on personal opinions, intuition, and judgment. In contrast to a quantitative approach, a subjective approach involves making investment decisions based on factors that may not be easily quantifiable or measurable. Subjective judgments can introduce individual biases into the decision-making process.

C is incorrect. An intuitive approach involves relying on one's instincts and “gut feeling” to make investment decisions. While some experienced investors may use their intuition as part of their decision-making process, it is generally less systematic and data-driven compared to a quantitative approach. Intuition, by its nature, is subjective and may not rely on quantifiable data and analysis.

Reading 25: Active Equity Investing: Strategies

Los 25 (a) Compare fundamental and quantitative approaches to active management