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
