In a new paper, Forecasting Factor Returns, Two Sigma proposes a methodology for estimating the return premia for the macro risk factors in the Two Sigma Factor Lens, the factor engine driving Venn.
The Two Sigma Factor Lens used by Venn provides a framework for analyzing multi-asset portfolios through broad, liquid, asset class proxy indexes (as discussed in Introducing the Two Sigma Factor Lens ).
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.
Since the publication of Introducing the Two Sigma Factor Lens , we have developed the lens further to include five equity style factors, marking an expansion from the “beta” component of the investment universe to the “risk premia” component.
While a factor lens can provide insight on a portfolio’s or investment’s historical sources of risk and return, we believe that choosing a desired allocation of factors or assets is a different exercise, one that requires forecasts of risk and return expectations.
In Forecasting Factor Returns , Two Sigma proposes a methodology for estimating the return premia for macro risk factors 1 in the Two Sigma Factor Lens used by Venn.
The paper introduces a handful of innovations intended to improve the accuracy of the long-term return forecasts. Specifically, the paper’s authors:
- Use new asset class return proxies to extend the analysis much further back than the daily return histories of most modern indices.
- Separate the Commodities factor (the most heterogeneous of the prior paper’s factors) into six sector-based factors for which the long-term premia are individually estimated. 2
- Apply (what they believe to be) common sense adjustments to long-term histories, such as slightly overweighting recent returns, to generate forward-looking estimates of each factor’s premium.
Venn plans to provide long-term macro risk factor return forecasts for users to use not only in portfolio optimization, but in other forward-looking portfolio and investment performance analyses. Stay tuned!
Contact the Venn team to learn more.
References
1 The paper does not include a return forecast for the Equity Short Volatility factor. This factor will likely be moved from a Secondary Macro factor to a Macro Style factor in a forthcoming update to the Two Sigma Factor Lens in Venn. The paper also does not include return forecasts for the Equity Style factors. These factors will be covered in future research. Nothing in this post or the associated paper should be considered a representation of how any research or methodology is actually used by Venn. Importantly, any use by Venn of research and methodology will differ materially from any research or methodologies discussed herein.
2 The Commodities factor in Venn continues to represent a combination of sectors as of the date of this post.
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