Portfolio diversification is a known strategy for minimizing risk, but these efforts can be thwarted if the diversified securities react in a similar way to market conditions. Factor investing is designed to reduce this risk by adjusting holdings based on specific attributes, and returns have been shown to increase if several factors are combined. A recent article in Chief Investment Officer magazine asserts that how factors are combined also makes a difference in investment outcomes.
Researchers at the global investment management firm AQR have found that rather than just “mixing” factors (eg. building one portfolio for value and a second for momentum and then combining the two), better results can be obtained through an “integrated” approach whereby investors would build one portfolio of assets that has been filtered for, say, both value and momentum. The authors of the study explain that this method results in “reasonably positive exposure to many styles rather than stocks with extreme exposure to one style that may simultaneously have extreme negative exposure to another style.” Said another way, integration essentially builds in additional layers of diversification depending on how many filters are included.
The study showed that integrated portfolios improved excess returns by 1% per year compared to mixed portfolios. The more factors were combined, the more returns increased.