Learning Outcomes
After reading this article, you will be able to distinguish between fundamental and quantitative approaches to equity factor investing, explain key traditional style factors, evaluate portfolio construction with style tilts, and assess the risks, logic, and implementation of factor-based equity strategies. You will understand how and why style tilts are used to generate excess returns over a benchmark and be able to analyze the role of factor timing and diversification for the CFA exam.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand and apply the principal aspects of active equity portfolio management, including the use of factor investing and style tilts as part of your broader revision for the exam. This article focuses on:
- Differentiating between fundamental and quantitative active management approaches
- Explaining major equity style factors (e.g., value, growth, momentum, quality, size) and their long-term performance patterns
- Understanding rationale and methods for implementing style tilts in active equity portfolios
- Assessing the trade-offs, risks, and expected outcomes when constructing factor-tilted portfolios relative to a benchmark
- Evaluating the role of factor timing and diversification in achieving active equity returns
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.
- What is the difference between a fundamental and a quantitative approach to active factor investing?
- Name three commonly used rewarded equity style factors and briefly describe their main signals.
- Why might an active equity manager apply a style tilt rather than simply holding a market-cap-weighted index?
- What are the key risks associated with style factor timing in equity portfolios?
Introduction
Active equity strategies commonly seek to outperform a market benchmark through factor investing and style tilts. Rather than holding a purely index-tracking portfolio, active managers identify and exploit systematic relationships in stock returns and adjust allocations accordingly. This article reviews how style factors such as value, growth, momentum, quality, and size are used in portfolio construction, and explains the rationale, implementation, and risks of factor investing and style tilting as evaluated in the CFA exam.
Key Term: factor investing
A systematic investment approach targeting specific, repeatable sources of return (factors), including but not limited to style signals such as value, momentum, growth, and size.
THE OVERVIEW OF ACTIVE EQUITY STRATEGIES
Fundamental vs. Quantitative Approaches
Active equity strategies can be classified as fundamental or quantitative in their decision processes.
Key Term: fundamental approach
Human judgment-based process relying on company research, valuation, and discretionary stock selection.Key Term: quantitative approach
Systematic, model-based process using historical data and algorithms to drive investment decisions.
Fundamental managers analyze company specifics, estimate fundamental value, and overweight/underweight based on analysis. Quantitative managers use statistical models and data to rank and select securities according to pre-set signals or factor exposures.
Factor-Based Strategies and Style Investing
Style factors are variables systematically associated with cross-sectional differences in equity returns. Persistent risk premia are often linked to:
- Value: stocks with low price-to-fundamental ratios (e.g., P/E, P/B, P/CF)
- Momentum: stocks with high past excess price performance
- Quality: companies with strong profitability, low indebtedness, or stable earnings
- Size: smaller market capitalization stocks tend to outperform larger ones over long periods (also known as the "size effect")
- Growth: stocks expected to deliver above-average earnings or revenue growth
Key Term: style tilt
A deliberate over/underweight to securities with particular style factor characteristics (e.g., value vs. growth, small cap vs. large cap), relative to the portfolio benchmark.Key Term: rewarded factor
A systematic risk variable with historic evidence of a long-term positive return premium (e.g., value, momentum, quality, size).Key Term: factor timing
Adjusting portfolio exposures to style factors dynamically, based on macro, valuation, or predictive signals, in an attempt to capitalize on forthcoming changes in factor performance.
Worked Example 1.1
Suppose an active equity manager believes value stocks will outperform in the next year due to attractive relative valuations. The manager tilts the portfolio by overweighting stocks with low P/E and P/B ratios, underweighting expensive growth stocks. What is this approach called, and what is the main risk they are taking?
Answer:
This approach is known as a style tilt toward value. The main risk is that the value premium may not materialize during the period, leading to underperformance if growth stocks continue to outperform value stocks.
IMPLEMENTING ACTIVE STYLE TILTS
Why Apply a Style Tilt?
Traditional market-cap-weighted indexes offer exposure to all common risk factors based on their market weights. Active managers seek additional returns by deviating from these market weights to capture factor premia. Reasons to apply a style tilt in an equity portfolio include:
- Forecasts that rewarded factors will outperform (e.g., after value underperforms, it may appear cheap and poised for mean reversion)
- Strategic diversification: combining factors with low correlation can improve the risk/return profile (e.g., mixing value and momentum)
- Meeting client preference for certain exposures (e.g., minimizing downside risk via low volatility or quality factors)
Portfolio Construction Techniques
Active approaches for style tilts include:
- Long-only tilt: Overweighting preferred factor(s) by selecting stocks with strong style signals, while staying within benchmark constraints.
- Long/short constructs and pure factor portfolios: Creating long/short positions to maximize exposure to desired factors, possibly dollar-neutral relative to the broad market.
- Multi-factor combination: Building diversified portfolios targeting more than one rewarded factor (e.g., combining value, momentum, and quality) to reduce cyclicality of single-factor returns.
Key Term: multi-factor strategy
Combining exposures to multiple rewarded factors to stabilize and diversify active returns.
Worked Example 1.2
A portfolio manager wants to add a momentum tilt. They allocate 60% to the benchmark index and 40% to the subset of stocks with the highest 12-month price return. What is this approach likely to improve and what is a possible downside?
Answer:
The approach should increase exposure to the momentum premium, possibly improving long-run returns if momentum persists. Downside risk is increased cyclicality—momentum can suffer sharp drawdowns, especially after market reversals.
Selecting Factor Signals
Implementation starts with clear factor definitions and rigorous backtesting. Managers may use raw signals (e.g., lowest 20% by P/E ratio for value; 12-month price change for momentum), or composite scores blending several related signals. Portfolio optimization helps balance risk and keep tracking error within acceptable limits.
Risks in Style Tilting
While rewarded factors offer potential for long-term excess returns, they periodically underperform the market and may experience protracted "dry spells." Key risks include:
- Crowding: Many managers chasing the same factor dilutes premia or causes sharp reversals.
- Timing error: Attempts to rotate between styles can lead to whipsaw and reduced returns if market turns are misjudged.
- Tracking error: Active tilting increases deviation from benchmark, which may result in short-term underperformance.
Worked Example 1.3
An equity portfolio combines 50% value, 25% momentum, and 25% quality, rebalanced quarterly. What practical benefits does this multi-factor approach offer over concentrating only on value?
Answer:
A multi-factor approach reduces the risk of large drawdowns and periods of underperformance when a single factor (e.g., value) is out of favor, as returns from different factors tend to be less than perfectly correlated.
Exam Warning
Style tilts may boost risk-adjusted returns over long periods but can lag the market for extended stretches. For exam questions, always state both the potential benefits and the risk of cyclically underperforming the benchmark.
Revision Tip
For CFA exam questions, you must be able to explain: (1) why style tilts may be appropriate, (2) how to choose and implement factor exposures, and (3) how to assess the practical risks and limits of timing or concentrating factor bets.
Key Point Checklist
This article has covered the following key knowledge points:
- Factor investing and style tilts are key active equity strategies for outperforming a benchmark
- Style factors (value, momentum, quality, size, growth) have long-term empirical support but can underperform cyclically
- Fundamental and quantitative approaches offer different strengths for identifying factor signals
- Multi-factor portfolios help manage periods when individual style factors lag
- Factor timing adds risk and can backfire if market regime changes are misjudged
- Active style tilts require clear definition, validation, and disciplined implementation to manage tracking error and unintended exposures
Key Terms and Concepts
- factor investing
- fundamental approach
- quantitative approach
- style tilt
- rewarded factor
- factor timing
- multi-factor strategy