The Integration of Factors Advantage

Investors Should Stop Mixing and Start Integrating Factor Strategies

An issue I am frequently asked to address is what’s the most efficient way to capture multiple investment style premiums in a long-only portfolio—the way most individuals invest. Thanks to AQR Capital Management’s researchers Shaun Fitzgibbons, Jacques Friedman, Lukasz Pomorski, and Laura Serban we know the answer. They addressed this question in their paper "Long-Only Style Investing: Don't Just Mix, Integrate," published in the Winter 2017 issue of The Journal of Investing. Specifically, they investigated two popular approaches that serve as common starting points for factor investors:

1. The Portfolio Mix Approach: This traditional method combines allocations to stand-alone indexes for each investment style (such as value, momentum, quality, etc.). Think of it as creating a portfolio of portfolios—each optimized for a specific factor.

2. The Integrated Portfolio Approach: This more sophisticated method integrates multiple styles directly into the portfolio construction process, considering all factors simultaneously when selecting and weighting securities.

Their data sample covered large stocks in developed countries (roughly the MSCI World benchmark universe) over the period from February 1993 to December 2015.

Key Findings: Integration Wins by a Wide Margin

The research produced a clear and compelling conclusion: integrating styles is a more effective way to harvest long-only style premiums compared to simply mixing separate style portfolios.

The integrated approach delivered substantial improvements across multiple performance metrics:

• Enhanced Returns: The integrated portfolio generated meaningfully higher returns than the portfolio mix approach—adding about 1% p.a. to excess returns versus the cap-weighted benchmark. The performance differences are larger: when factors are negatively correlated (such as value and momentum); when investors target relatively higher tracking error; and more individual styles are combined.

• Superior Information Ratio: Risk-adjusted performance was significantly better (about 40%), indicating more efficient use of risk budget.

• Reduced Conflicting Exposures: The integrated method successfully avoided stocks with offsetting style characteristics that can dilute performance—stocks with balanced, positive exposures to multiple styles realize higher excess returns on average and hence are better bets than stocks that may have an extreme exposure to one style, but at best modest exposure to other factors.

• Reduced Trading Costs and Improved Tax Efficiency: By netting trades that would have been executed in separately managed single style portfolios, turnover is reduced (about 5-10%), lowering trading costs and can improve tax efficiency.

Why Integration Outperforms Mixing

The superior performance of the integrated approach stems from a fundamental insight into how investment styles interact within a portfolio. When you simply mix separate style-based indexes, you inevitably end up holding stocks that may score well on one factor but poorly on others. This creates internal conflicts that dilute the effectiveness of each premium style.

For example, a portfolio mix might include:

• A value stock that scores poorly on quality metrics.

• A momentum stock that's expensive.

• A quality stock with negative momentum.

The integrated approach eliminates these conflicts by evaluating each potential holding across all style dimensions simultaneously, creating a more coherent and effective portfolio.

Their findings led the authors to conclude: “Our analysis indicates that the benefits of integration increase for mandates that seek to combine many styles, especially those with low or negative correlations to one another, and for mandates that target higher active risk.”

Key Takeaways for Investors

1. Rethink Your Multi-Factor Strategy

If you're currently using a portfolio mix approach—combining separate ETFs or funds for value, momentum, quality, and other factors—the research suggests you likely leaving significant performance on the table.

2. Look Beyond Simple Factor Mixing

When evaluating factor products, dig deeper into their construction methodology. Products that integrate multiple factors simultaneously may offer better risk-adjusted returns than those that simply combine separate factor exposures.

3. Factor Interactions Matter

The research underscores that investment factors don't operate in isolation. Understanding how different styles interact and potentially conflict with each other is crucial for effective factor investing.

4. Question Traditional Approaches

Just because portfolio mixing is a common and intuitive approach doesn't mean it's optimal. This research demonstrates the value of questioning conventional wisdom and seeking more sophisticated solutions.

Summary

The message from this research is clear: when it comes to harvesting multiple style premiums in long-only portfolios, integration trumps simple mixing. Investors seeking to maximize the benefits of factor investing should prioritize strategies that consider multiple factors simultaneously rather than combining individual single-factor approaches as combining factors may be just as important as which factors you choose.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.