Active equity strategies - Fundamental quantitative and hybr...

Learning Outcomes

After reading this article, you will be able to distinguish between fundamental, quantitative, and hybrid active equity strategies; explain their rationales, decision processes, and key portfolio construction features; recognize the role of active share and active risk; and evaluate the implications of each style for assessment and exam scenarios.

CFA Level 3 Syllabus

For CFA Level 3, you are required to understand the core differences and assessment implications of active equity strategies. In particular, you should be able to:

• Explain the characteristics and processes of fundamental, quantitative, and hybrid active equity strategies
• Compare bottom-up and top-down methods within each approach
• Analyse portfolio construction and risk control across strategies
• Describe the uses and interpretation of active risk and active share in evaluating managers
• Discuss typical pitfalls, especially related to behavioral bias and model risk

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Define the primary difference between fundamental and quantitative active equity strategies.
2. What does “active share” indicate about an equity portfolio?
3. Give one example of a hybrid active equity strategy and explain how it combines features of both fundamental and quantitative methods.
4. Why might high turnover not always result in lower tax efficiency in quantitative portfolios?

Introduction

Active equity strategies seek to outperform benchmark indices by using different processes to select and weight securities. At Level 3 you must compare fundamental, quantitative, and hybrid approaches, understand their practical and theoretical foundations, and apply these distinctions to portfolio and manager assessment. This article presents the key features required for the CFA exam.

STRATEGY CLASSIFICATION AND KEY FEATURES

Active equity strategies can be broadly divided into three types: fundamental, quantitative, and hybrid.

Fundamental Strategies

A fundamental approach relies on human judgment to evaluate companies, sectors, or markets using financial data, industry analysis, and management assessment. Security selection is typically based on analyst discretion, supported by financial modelling.

Key Term: fundamental active strategy
An investment process that relies primarily on human analyst judgment, financial statement review, and qualitative assessments to select stocks expected to outperform.

Quantitative Strategies

A quantitative strategy systematically applies rule-based models to analyze large data sets and identify factors or patterns that predict future equity returns. Portfolio construction is generally optimized and implemented automatically across a broad universe.

Key Term: quantitative active strategy
An investment process using systematic, model-driven approaches based on statistical analysis and coded rules to forecast returns and build portfolios.

Hybrid (Fundamental-Quantitative) Strategies

Hybrid approaches combine elements of fundamental and quantitative methods. For example, quantitative signals may be used to screen a universe, with fundamental analysis applied to the final selection, or vice versa. Portfolio construction may combine optimization with discretionary adjustments.

Key Term: hybrid active strategy
A strategy that integrates both discretionary (human) judgment and systematic (model-based) elements in security selection, weighting, or portfolio risk control.

INVESTMENT PROCESS AND DECISION MAKING

Decision Process

• Fundamental managers form judgments about company value and prospects using qualitative and quantitative data.
• Quantitative managers use defined rules, factor screens, and historical patterns, minimizing judgment after initial model design.
• Hybrids use systematic tools to supplement discretionary decision making or apply judgment to refine model outputs.

Security and Portfolio Selection

• Bottom-up: Focus on characteristics of individual stocks first.
• Top-down: Begin with macro, sector, or factor themes and allocate accordingly.

Portfolio Construction and Risk Management

• Fundamental portfolios may be concentrated, focusing on best ideas, or diversified by applying risk limits or sector constraints.
• Quantitative portfolios usually hold many stocks, controlled by optimizer constraints and factor exposures to control risk.

Key Term: active share
A measure of how much a portfolio's holdings differ from its benchmark index, calculated as half the sum of the absolute differences in weights.

Key Term: active risk
The standard deviation of the difference between a portfolio’s returns and its benchmark’s returns, also referred to as tracking error.

Worked Example 1.1

A portfolio manager claims to run a “quantitative” strategy, but routinely overrides model signals based on subjective judgment. Is this truly a quantitative approach?

Answer:
No. A purely quantitative strategy minimizes ongoing intervention after the model is set. Frequent subjective overrides indicate a hybrid or discretionary process, not a strict quantitative approach.

Key Differences and Assessment

Worked Example 1.2

A CFA candidate is shown two portfolios. Portfolio X holds 45 stocks with significant sector overweights, selected by an analyst team. Portfolio Y holds 400 stocks, weighted by a multi-factor optimizer, and never adjusted by hand. Which is more likely to have higher active share?

Answer:
Portfolio X. Concentrated discretionary portfolios typically have higher active share than diversified, systematically optimized portfolios.

Common Pitfalls

• Behavioral Bias: Fundamental strategies can be prone to confirmation bias, overconfidence, and other judgment errors. See “Exam Warning” below.
• Model Risk: Quantitative strategies are exposed to overfitting, data mining, hindsight bias, and risk of model breakdowns in new environments.
• Hybrid Risk: May suffer from lack of discipline, inconsistent application, or unclear responsibility for outcomes.

Worked Example 1.3

Is a momentum strategy always less tax efficient than a value strategy because it typically results in higher turnover?

Answer:
Not necessarily. While turnover is higher, momentum approaches generally realize losses quickly and let gains run, allowing tax losses to offset other gains. Value strategies may trigger regular gains realization by selling appreciated positions, potentially reducing tax efficiency.

Exam Warning

Many candidates confuse active share with active risk. Remember: active share measures difference in holdings (regardless of volatility), while active risk measures return variability relative to the benchmark.

HYBRID STRATEGIES: EXAMPLES

A hybrid strategy may include:

• Quantitative screens for a fundamental research universe, followed by discretionary analyst picks
• Model-driven recommendations with human override for unusual events or limited data
• Optimizer-generated weights, adjusted for analyst conviction

These combinations seek to balance systematic breadth and human judgment, but may introduce ambiguity or inconsistent application of process.

Revision Tip

For the exam, be able to define each approach, identify decision and risk management differences, and state when active share or active risk is useful in comparing two managers or styles.

Summary

Active equity strategies fall into fundamental, quantitative, and hybrid categories. Each uses different information, processes, and risk controls. For CFA Level 3, recognize that active share and active risk are distinct, and be ready to evaluate when and why a strategy or manager is classified under each approach for portfolio construction and performance assessment.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish fundamental, quantitative, and hybrid active equity strategies
• Define and compare active share and active risk
• Recognize process, risk, and portfolio construction features of each strategy
• Identify typical pitfalls and behavioral or model risk issues in each approach
• Understand the role of hybrids and how features are combined

Key Terms and Concepts

• fundamental active strategy
• quantitative active strategy
• hybrid active strategy
• active share
• active risk