Introducing the Two Sigma Factor Lens

By Geoff Duncombe and Bradley Kay on October 9, 2018

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

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  1. Methods 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.
  2. Venn is an analytics platform provided by Two Sigma Investor Solutions, LP, to support portfolio management and manager evaluation needs of allocators.

This article is not an endorsement by Two Sigma of the papers discussed, their viewpoints or the companies discussed. The views expressed above reflect those of the authors and are not necessarily the views of Two Sigma Investments, LP or any of its affiliates (collectively, “Two Sigma”). The information presented above is only for informational and educational purposes and is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. Additionally, the above information is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice. Two Sigma makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever. Click here for other important disclaimers and disclosures.

Important Notice to Venn Subscribers: This article and the associated paper is not an offer to, or solicitation of, any potential clients for Venn or otherwise for the provision of investment management, advisory or any other services. Nothing in this article or the paper should be considered a representation of how the Two Sigma Factor Lens may be used on Venn or about Venn or the Two Sigma Factor Lens in any respect. Importantly, any use by Venn of the Two Sigma Factor Lens may differ materially from any content, research or methodologies discussed in the article or the paper.