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Active Equity Investing: Strategies

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Active equity investing involves portfolio managers making specific investments with the goal of outperforming a benchmark index through various strategies. In the context of CFA Level 3 and Equity Investments, active strategies are crucial as they reflect the practical application of investment th…

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CFA Level 3 - Active Equity Investing: Strategies Example Questions

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Question 1

As the head of active equity investing at a large pension fund, you are evaluating the performance of a fund manager who employs a factor-based investment strategy. The manager's portfolio has consistently outperformed the benchmark by focusing on stocks with high exposure to the value, momentum, and quality factors. However, upon analyzing the portfolio's risk profile, you notice that the fund's tracking error has increased significantly over the past year, exceeding the limit set by the pension fund's investment guidelines. The manager attributes the increased tracking error to the portfolio's heavy overweight in the value factor, which has experienced heightened volatility recently. The manager proposes maintaining the current factor exposures, arguing that the value factor is poised for a rebound. As the head of active equity investing, how would you respond to the manager's proposal?

Correct Answer: Recommend that the manager rebalance the portfolio to reduce the overweight exposure to the value factor and bring the tracking error within the acceptable limit, while still maintaining a tilt towards the value, momentum, and quality factors.

The best course of action is to recommend that the manager rebalance the portfolio to reduce the overweight exposure to the value factor and bring the tracking error within the acceptable limit, while still maintaining a tilt towards the value, momentum, and quality factors. As the head of active equity investing, it is important to ensure that the fund manager adheres to the pension fund's investment guidelines and risk limits. The increased tracking error, caused by the heavy overweight in the value factor, has exceeded the acceptable limit set by the fund. This poses a significant risk to the portfolio and may lead to unintended consequences. While the manager's argument for maintaining the current factor exposures based on the potential rebound of the value factor has merit, it is essential to balance the risk and return objectives of the pension fund. By rebalancing the portfolio to reduce the value factor overweight, the manager can bring the tracking error back within the acceptable range while still benefiting from the exposure to the value, momentum, and quality factors. The other two options are less desirable because they either ignore the risk limits set by the fund or introduce additional complexity by reallocating to the low volatility factor, which may not align with the manager's original investment strategy.

Question 2

As the head of active equity investing at a large asset management firm, you are evaluating the performance of a fund manager who employs a value-oriented strategy. The manager focuses on identifying undervalued companies with strong fundamentals and holds a concentrated portfolio of 20-30 stocks. Over the past year, the fund has underperformed its benchmark by 3%, primarily due to its overweight position in the energy sector, which has experienced significant volatility. The manager believes that the energy sector is poised for a rebound and has increased the fund's allocation to the sector. As the head of the department, you need to assess the manager's investment thesis and decide whether to approve the increased allocation to the energy sector, considering the fund's risk profile and long-term objectives.

Correct Answer: Request a detailed report from the fund manager outlining their investment thesis for the energy sector, including a thorough analysis of the sector's fundamentals, potential catalysts, and risk factors. Based on the report, assess whether the increased allocation aligns with the fund's risk profile and long-term objectives. If the investment thesis is compelling and the risks are well-managed, approve the allocation increase while closely monitoring the fund's performance and risk exposure.

The best approach would be to request a detailed report from the fund manager outlining their investment thesis for the energy sector. This report should include a thorough analysis of the sector's fundamentals, potential catalysts, and risk factors. By reviewing this report, you can assess whether the increased allocation aligns with the fund's risk profile and long-term objectives. If the investment thesis is compelling and the risks are well-managed, it would be appropriate to approve the allocation increase while closely monitoring the fund's performance and risk exposure. Simply approving the increased allocation without due diligence would not be prudent, as it is important to understand the reasoning behind the manager's conviction and ensure that it aligns with the fund's goals and risk tolerance. On the other hand, rejecting the request outright and instructing the manager to reduce exposure to the energy sector may be premature. While the sector's volatility and the fund's recent underperformance are concerns, it is essential to consider the manager's expertise and the potential for the sector to rebound. By reviewing the detailed report, you can make an informed decision based on the strength of the investment thesis and the fund's specific circumstances.

Question 3

As the head of active equity investing at a global investment firm, you are evaluating the performance of a fund manager who employs a bottom-up, fundamental analysis approach to stock selection. The manager's portfolio has outperformed the benchmark by 3% annually over the past five years, primarily due to strong stock selection in the healthcare and technology sectors. However, the portfolio's tracking error has been higher than the firm's target range of 3-5%, and the manager's high conviction positions have led to increased concentration risk, with the top 10 holdings accounting for 40% of the portfolio. The investment policy allows for a maximum of 35% allocation to the top 10 holdings. As the head of active equity investing, how would you address the situation?

Correct Answer: Schedule a meeting with the fund manager to discuss the portfolio's risk profile and explore ways to maintain the portfolio's strong performance while reducing concentration risk and tracking error, such as gradually trimming positions in the top holdings and increasing diversification across sectors and individual stocks.

The best approach would be to schedule a meeting with the fund manager to discuss the portfolio's risk profile and explore ways to maintain the strong performance while reducing concentration risk and tracking error. This could involve gradually trimming positions in the top holdings and increasing diversification across sectors and individual stocks. Immediately reducing the allocation to the top 10 holdings to 35% to comply with the investment policy could lead to selling positions that have contributed significantly to the portfolio's outperformance, potentially impacting future returns. Allowing the fund manager to maintain the current portfolio structure and concentration levels, even given the strong performance, would not address the issue of the portfolio's risk metrics being outside the firm's target range. As the head of active equity investing, it is important to ensure that all portfolios adhere to the firm's risk management guidelines while striving for optimal performance.

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