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Many investors acknowledge the merits of factor investing but disagree on how to implement it. The key question is whether to mix stand-alone factor ‘sleeves’ or to construct a bottom-up integrated multi-factor portfolio.
One of the fastest growing themes in investment management today is factor-based investing. Although some investors may have good reasons to focus on a single factor or a set of particular factors, the general consensus is that one should hold a portfolio which is well-diversified across various factors that have been shown to deliver significant premiums in the long run.
A multi-factor allocation offers investors exposure to various factors, avoiding large concentrations in any single strategy that expose their capital to the risk of short-run underperformance of any given style.
The key question is whether to mix stand-alone factor ‘sleeves’ or to construct a bottom-up integrated factor portfolio. The factor mix approach entails allocation to single-factor strategies that are constructed to provide maximum exposure to a chosen factor. This approach is transparent, convenient for performance attribution, and also allows for tactical factor allocation.
In most cases, however, this approach ignores the fact that a strategy which targets one specific factor may implicitly bring along undesired negative exposures to other factors. As a consequence, mixing single-factor sleeves can result in sub-optimal and unintended exposures at the overall portfolio level. The proponents of the integrated approach use this as their main argument, claiming that one can achieve better performance characteristics by combining factors optimally from the outset. They do so by selecting stocks with the highest integrated factor scores. Some other advantages of this approach are transaction cost netting and a moderate decrease in turnover.
Another important distinction should be made between ‘generic’ single-factor strategies based on a single factor model, and ‘enhanced’ single-factor strategies that are designed to eliminate unintended exposures to other factors. Generic single-factor factor strategies tend to be suboptimal compared with enhanced factor strategies. For instance, some generic value strategies do not provide much exposure to the value premium to begin with. Other generic value factor strategies do provide a high degree of value exposure, but are only able to do so by accepting significant negative exposures to other factors.
Enhanced single-factor strategies provide many advantages of the single-factor sleeves, while overcoming the pitfalls mentioned above. For instance, adding some momentum and quality exposure to value strategies helps to avoid the so called ‘value traps’ (stocks that are cheap for a reason) and adding value to momentum or quality helps to avoid the most overpriced stocks. As the integration of other factors is only partial, the main return driver remains the selected factor premium. These ‘enhanced’ factor strategies can be further mixed into multi-factor vehicles, but interestingly, this approach has not been a subject of thorough investigation by the literature that explores the ways in which factors can be combined into multi-factor portfolios.
Investigating which approach is better - bottom-up integration or mixing single-factor strategies -Ghayur, Heaney, and Platt (2016) argue that a preference for one or the other ultimately depends on the main objectives of the asset owner. They find that both approaches are viable options.
Leippold and Rueegg (2017) consider a richer set of factor combinations, robust statistical tests, and longer time periods to conclude that integrated portfolios do not outperform the mixed ones. While they do find that the integrated approach lowers the overall portfolio risk through better portfolio diversification, this lower risk is accompanied by a lower return. In fact, any difference in risk between the two approaches can be explained by a higher exposure of the integrated portfolio to the low-risk anomaly. The authors find no evidence in support of one approach over the other.
To summarize, it seems that, empirically, there is not much difference between the integrated and the mixed approach.
If the integrated approach is not intrinsically superior to the mixed approach, nor the other way around, does this mean that it does not really matter how one goes about constructing factor portfolios? Absolutely not! In a theoretical world without transaction costs and with the flexibility to lever portfolios up or down as much as one likes, any desired factor profile may be obtained using whatever factor strategies are available. But in reality investors can only invest a dollar once, transaction costs are important, and the application of leverage is severely constrained. Attractive factor solutions are the ones that deliver the highest amount of factor exposure for any given level of active risk, and that do not disregard other factors.
Regardless of whether they are mixed ore integrated, enhanced factor strategies tend to be preferable to generic single-factor solutions. They apply partial factor integration to ensure that stocks that have negative expected return contributions from other factors do not end up in the portfolio. Subsequently, these enhanced single factors can be further mixed into multi-factor vehicles or, alternatively, the investor can opt for an integrated strategy that is designed to provide high exposures to multiple factors in the most efficient way.