Active Equity Investing: Strategies

Active equity managers promise to beat a benchmark after fees, and a client or consultant must understand how each one tries to do it. This module contrasts fundamental and quantitative approaches and the biases that distort each, analyzes bottom-up, top-down, factor-based and activist strategies, explains statistical arbitrage and microstructure trading, and shows how to classify a manager's style with holdings and returns data.

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What you will learn

1. Contrast fundamental and quantitative approaches to active equity management, and describe how each type of strategy is created and the biases that can distort it.

Fundamental: research-led, forward-looking, concentrated, conviction-weighted; quantitative: rules-led, historical data, broad, optimized.
The information coefficient (rank correlation of scores with later returns) measures a quantitative signal's predictive power.
Survivorship bias, look-ahead bias, data mining and ignored costs inflate backtests.
Fundamental managers are exposed to behavioural biases such as confirmation bias and overconfidence.
Both processes need a stated rationale for why the opportunity exists and why it should persist.

2. Analyze bottom-up, top-down, factor-based and activist strategies, including the rationale behind each and the process used to implement it.

Bottom-up value styles: relative value, contrarian, high-quality value, income, deep value, distressed, special situations.
GARP screens growth stocks on PEG = P/E / expected growth (in percent).
Top-down: country and currency allocation, sector rotation, volatility-based and thematic strategies.
A factor's return is measured with a hedged portfolio: long the top quintile, short the bottom quintile.
Activists take sizeable stakes and push for change; risks include concentration, cost and failure of the campaign.

3. Describe statistical arbitrage and market-microstructure strategies, including pairs trading, and the risks they carry.

Pairs trading: when the spread between two related stocks is about 2 standard deviations from its mean, sell the rich one and buy the cheap one.
The trade is market-neutral: profit comes from the spread reverting, not from market direction.
Main risks: structural breaks in the relationship, crowding and forced deleveraging.
Microstructure strategies earn the bid-ask spread or exploit order flow; they need speed and low costs and have limited capacity.
High turnover makes trading costs decisive for these strategies.

4. Classify equity investment styles using holdings-based and returns-based analysis, and discuss the limitations of style classification.

Style dimensions: value, core, growth, and large, mid, small; also momentum, quality and volatility.
Holdings-based analysis aggregates characteristics of current holdings: precise but a snapshot, data-hungry and definition-dependent.
Returns-based analysis regresses returns on style indexes (weights >= 0, summing to 1): easy but lagging and sensitive to correlated indexes.
A portfolio of extremes can average out to 'core'; look at the distribution, not just the average.
Use both methods and watch for style drift after poor relative performance.

Module at a glance

Fundamental managers are research-led and concentrated; quantitative managers are rules-led, broad and optimized.
Judge a quantitative signal by its information coefficient over many periods, out of sample and after costs.
Survivorship, look-ahead and data-mining biases inflate backtests; behavioural biases threaten fundamental managers.
Bottom-up value and growth (GARP: PEG = P/E / growth) versus top-down country, sector, volatility and thematic strategies.
Factor returns come from long top-quintile, short bottom-quintile portfolios; activists create value by forcing change.
Pairs trades sell the rich leg and buy the cheap leg when |z| is about 2 or more; the main risk is a broken relationship.
Combine holdings-based and returns-based style analysis, and watch averages that hide barbells and style drift.

This free module has 4 lessons, 16 practice questions with full explanations and 1 essay case with a model answer.

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