For many years, investors relied on the assumption that combining different asset classes within a portfolio was an effective way to maximize risk-adjusted returns.
A key issue with that assumption, however, is that different asset classes may be exposed to the same systematic sources of risk, or risk factors, which may lead investors to believe they are more diversified than is actually the case.
In contrast, examining a portfolio through a risk factor lens may allow investors to better understand overlapping sources of risk across multiple asset classes and more efficiently manage their portfolios’ overall risk exposures and expected return.
In a recent paper, we provide an overview of the Two Sigma Factor Lens, designed for analyzing multi-asset portfolios and derived from returns of broad, liquid asset class proxy indexes.
This lens is intended to be:
- Holistic, by capturing the large majority of cross-sectional and time-series risk 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.
Finally, the paper discusses methods for constructing and assessing the Two Sigma Factor Lens that can be extended to produce additional risk factors for new sub-asset classes or cross-sectional risks that may not currently be captured by the lens.1 This factor lens, and our ongoing work to expand it, form the foundations of the Venn™ platform.2
References:
1Methods outlined in this paper for building a functional risk factor lens for major asset classes can be extended to produce risk factors for investment styles and key sub-asset classes. This is an area of continuing research and development as Two Sigma builds out this lens to accommodate a broader array of institutional investments.
2Venn is an analytics platform provided by Two Sigma Investor Solutions, LP, to support portfolio management and manager evaluation needs of allocators.
The information contained in this article is provided for general informational and educational purposes only, and should not be construed as investment advice. The contributor to this material is associated with a client of Two Sigma Investor Solutions, LP (“TSIS”). Neither TSIS nor its affiliates have compensated the contributor for his statements. The statements from the interview have been edited and reformatted by TSIS with the contributor’s approval. Unless otherwise noted, the contributor’s statements do not represent the actual views or opinions of TSIS or its affiliates, or any officers, directors, or employees thereof.
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