Venn Pillar Series 1 of 4: The Practice of Understanding Portfolio Risk with Orthogonal Factors

“In theory there is no difference between theory and practice. In practice, there is.”

-Yogi Berra

Many investors believe, in theory, that asset classes are diversified. In practice, they have overlapping risks and are often less diversified than one might think. This gap between theory and practice, to us, results from an imperfect understanding of what drives portfolio risk. 

Typical “Credit” Exposures Are More Than Just Credit

For example, let’s use Venn to take a look at the factor contribution to risk of a typical credit exposure, such as the SPDR Bloomberg High Yield ETF (HY ETF).

Perhaps surprising to some, we found that historically the equity factor has driven the majority of risk for this fixed income fund at 33%.¹ Furthermore, when we created a 50/50 portfolio using this HY ETF and broad global equities, the equity factor would have contributed 87% to total risk.²

Factor Contribution to Risk of a 50/50 Portfolio of High Yield and Equity

Source: Venn by Two Sigma. The chart displays factor analysis for a 50/50 split between the SPDR Bloomberg High Yield ETF and iShares MSCI ACWI ETF viewed through the Two Sigma Factor Lens from 3/27/2008–11/23/2023

Despite half of this portfolio being a type of fixed income and the other equity, it turns out they are not very diversifying together. This is a critical insight when discerning the difference between the theory of understanding portfolio risk, and the practice of it. 

Venn’s Factors Are Independent and Diversifying

Many investment categories, including asset classes, are concoctions of common risk factors. At Venn, we believe that independent risk factors spanning across asset classes are more precise tools for investment analysis. Viewing risk this way may help to better understand portfolio diversification and the impact of decision making. 

This is why the Two Sigma Factor Lens that powers Venn:

1. Evaluates investments with a parsimonious lens of risk factors rather than asset classes.
2. Aims for all 18 risk factors to be orthogonal, or statistically independent.
   
   

The second point is really the key. Within Venn, we can show how virtually every factor correlation pair, via our construction, is low or close to zero (below). This creates a precise and independent lens with which to view portfolios and make investment decisions. Put another way, an allocator seeing relatively dispersed exposure to multiple factors in the Two Sigma Factor Lens can be more assured that their portfolio is diversified among many independent sources of return. 

Source: Venn by Two Sigma. The chart displays a correlation matrix for all 18 factors in the Two Sigma Factor Lens over their full history from 10/3/1997-11/23/2023

Using Venn to Close the Gap

Viewing a portfolio from an asset class perspective has its benefits, including intuitive categorization and a wealth of available research. However, we believe a purer approach to risk can also be additive. By viewing investments through a risk lens made up of independent factors, in our view, it’s easier to understand the true diversification of a portfolio and the deeper factors at play. 

Venn is unique in that it uses Two Sigma research and industry leading technology to deliver this independent factor lens pre-packaged, closing the gap between the theory of understanding portfolio risk, and the practice of it. Borrowing another quote from Yogi Berra:

“if you don’t know where you’re going, you’ll end up someplace else.”

-Yogi Berra

This post marks the first in a series of four on the fundamental pillars of Venn (see below). Stay tuned for an upcoming post on another core pillar. 

• Holistic, by capturing the large majority of cross-sectional and time-series risks for typical institutional portfolios.
• Parsimonious, by using as few factors as possible.
• Orthogonal, with each risk factor capturing a statistically uncorrelated risk across assets.
• Actionable, such that desired changes to factor exposure can be readily translated into asset allocation changes.

References

¹ Source: Venn by Two Sigma. Period from 3/27/2008–11/23/2023

² Source: Venn by Two Sigma. Broad global equity represented by the iShares MSCI ACWI ETF. Period analyzed from 3/27/2008–11/23/2023

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