Smart Beta Multi-Factor Construction Methodology: Mixing vs. Integrating

The authors compare the qualitative properties as well as the risk and return profiles of simulated multi-factor portfolios constructed in accordance with two different methodologies. The first, the integrating approach, is a process that searches the universe for securities that have exposures to various target factors and selects the ones with the highest composite scores. The second, the mixing approach, achieves the desired exposure to multiple factors by allocating assets across single-factor portfolios. The authors tested portfolios designed to capture value, momentum, profitability, investment, and low-beta factor premia. Integrating outperformed mixing absolutely and on a risk-adjusted basis. The integrating strategy, however, proved to have higher concentration and turnover, resulting in idiosyncratic active risk and estimated transaction costs that reduced its return advantage over the mixing strategy. In addition, the mixing approach offers the practical benefits of transparency, flexibility, and ease of performance attribution. These features make mixing a viable choice, especially for investors and practitioners in a principal/agent relationship.