Smart beta products that focus on a single factor have gained increasing acceptance over the last 15 or so years. Only a handful of the myriad factors identified in the literature have been shown to be robust over the long run. Based on strong empirical evidence, as provided by Hsu and Kalesnik (2014) and Beck et al. (2016), the value, low beta, momentum, and illiquidity factors are robust in the absence of transaction costs, whereas the quality and size factors do not earn a return premium consistently over time and across different regions.
Each of these factors has had long periods of underperformance, such as the large losses experienced by low-volatility investors in the 1990s and those of value investors during the tech bubble. Unsurprisingly, to even out performance and to hedge away the risk of lengthy bouts of poor returns, investors have come to favor the more-diversified approach of multi-factor strategies, which offer a “smoother ride” through economic and market cycles (Brightman et al., 2017).
Multi-factor strategies do not just happen, however, they need to be designed and portfolios constructed. Not everyone, of course, agrees on the best method for constructing a multi-factor strategy and the implications of the method for investor outcomes. How then should investors assess which approach is more suitable—mixing or integrating—and whether to apply it in a quant active or a passive manner?
Mixing (top-down) is a two-step process. The first step is to create single-factor portfolios, and the second step is to allocate assets across them to form a multi-factor portfolio. Integrating (bottom-up) is a one-step process, which involves surveying suitable securities across an opportunity set and selecting those with the strongest combined exposures to all target factors.
Let’s take a simple two-factor example to illustrate each approach.
First, let’s consider the mixing approach. The dots in the mixing scatterplot represent the universe of stocks, ranked across two dimensions: momentum on the y-axis and value on the x-axis. The first step is to create a value sleeve, which contains the cheapest stocks, as illustrated by those in the blue box at the far right of the growth–value x-axis, and a momentum sleeve, which comprises the most-recent winners, as illustrated by the stocks in the green box at the top of the winners–losers y-axis. We then combine the two sleeves, giving each a 50% weight, to form the two-factor mixing portfolio.