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Markets & Economy

Two Sigma Factor Lens: Forecasting Factor Returns

Insights by Geoff Duncombe, Mike Nigro, Bradley Kay

A recent Two Sigma paper, Introducing the Two Sigma Factor Lens, provided a framework for analyzing multi-asset portfolios through a lens comprised of broad, liquid, asset class proxy indexes.

As a reminder, the Two Sigma Factor 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.

This factor lens, and our ongoing work to expand it, form the foundations of the Venn™ platform.1

The missing ingredient: factor return forecasts

While a factor lens may help provide insight on a portfolio’s historical sources of risk and returns, choosing a desired allocation of factors or assets is a far trickier issue. Doing so requires forecasts of risk and return expectations.

In a new paper, Forecasting Factor Returns, we propose a methodology using historical data to quantify the return premia for major asset-class based factors.

The paper introduces a handful of innovations intended to improve the accuracy of our long-term return forecasts. Specifically, we:

  • Use new asset class return proxies to extend our analysis much further back than the daily return histories of most modern indices.
  • Separate the most heterogeneous of the prior paper’s factors, Commodities, into six sector-based factors for which the long-term premia are individually estimated.
  • Apply (what we believe to be) common sense adjustments to long-term histories — slightly overweighting recent returns and applying empirically-based shrinkage across the observed historical Sharpe ratios to generate our forward-looking estimates of each factor’s premium.
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Footnotes

  1. 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.