Authors: Geoff Duncombe (Two Sigma), Bradley Kay (Two Sigma)
Abstract: Asset allocators have taken an increasing interest in risk factors for the analysis of everything from their overall portfolios to their individual managers. Most of the literature on the topic discusses why allocators should apply a risk factor approach. This paper instead focuses on how to construct a functional lens suiting institutional investors’ analytical needs. Specifically, we present a framework for constructing a parsimonious set of actionable risk factors that individually describe independent risks common across many asset class returns yet collectively explain much of the cross-sectional and time-series risk in typical institutional investor portfolios.