This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.
On the cutting edge of investment management, where investors are migrating from a style-box-driven approach to a multifactor approach, there remains a significant debate as to the best way to combine factors in a single portfolio.
The benefit of a multifactor approach can be distilled into a single word: diversification. While most well-known factors have historically exhibited long-term alpha, they can also exhibit significant short-term tracking error. By combining multiple factors into a single portfolio, the volatility of relative performance can be significantly reduced.
Debate exists, however, on the best way to actually build a multifactor portfolio, with two prominent camps.
The Mixed Approach
A mixed approach is one in which a portfolio is built for each target factor individually, and those portfolios are combined as sleeves to create a multifactor portfolio.
For example, let’s assume there is a portfolio trying to provide exposure to value, size, momentum and low-volatility factors. In the mixed approach, the manager would build a value portfolio, a small-cap portfolio, a high momentum portfolio and a low-volatility portfolio. The manager would then combine these four portfolios as sleeves of a single portfolio.
To use the language of a style-box-driven approach, a mixed-approach portfolio seeking both “small cap” and “value” exposure would have a 50% weight to value stocks (regardless of capitalization) and a 50% weight to small-cap stocks (regardless of growth/value classification). You would end up holding the stocks in the following buckets:
Mixed approach managers argue that this approach allows the full spectrum of value and size factors to be introduced. Integrated-approach managers, as we will see later, would argue that the introduction of large-cap stocks or growth stocks dilutes the overall target factor exposures.