Food for Thought: Integrating vs. Mixing

Key Points

  • The diversified approach of a multi-factor strategy offers a “smoother ride” through economic and market cycles than a single-factor strategy.
  • Investors should consider both the quantitative and qualitative characteristics of the two most popular multi-factor strategy construction methods—mixing and integrating—before deciding which is best suited for achieving their desired investment outcome.
  • Integrating can be a good candidate for a quant active strategy when high active risk is allowed, capacity is not the primary concern, and sophisticated implementation can mitigate trading cost concerns.
  • Investors who value full transparency, diversification, minimal governance oversight, and low fees, should find a mixing multi-factor index strategy a sensible choice.

Many of us know the painstaking process of weaning infants onto solids and persuading them to try new foods. We as parents constantly grapple at the mystery of what drives their likes and dislikes. An early favorite of many Brits is peas, chopped bangers, and mash (to those unfamiliar with British vernacular, these latter two are known more commonly as sausages and mashed potatoes). To more effectively shovel in this new form of sustenance, we combine all three together into one unsightly mess and, with one hand trying to stabilize the baby, scoop up the sticky texture and go for gold.

Whereas integrating all elements into a single conglomeration can be very efficient, human nature can be inexplicable, and sometimes the previously successful combination of peas, bangers, and mash fails miserably on subsequent attempts. Instead of the open invitation of a gaping mouth, the infant shuts up shop and stubbornly refuses to consider even a single mouthful, swatting away the spoon, creating a royal mess, and leaving his or her parents in despair—a wasted dinner!

When behavior deviates from past experience, we want to understand the reason why. What ingredient or ingredients does the child no longer like? If we had instead attempted to shovel each of the foods in separately, it might have been easier to determine the source of the problem. The approach we take in constructing a multi-factor strategy follows a similar line of reasoning: creating a portfolio of stocks with individual factor characteristics or stocks that satisfy the criteria across all factors. In this article, we compare the two most popular multi-factor strategy construction methods of mixing and integrating, and recommend when each of the two strategies is the more suitable for an investor’s needs.

Why Multi-Factor Investing?

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?