In the investment world, there are seemingly endless factors that can be used to evaluate strategies. Asset class, country, sector, and industry are just to name a few, each branching out to numerous possibilities.
However, if we created a model that included every possible factor in the world, we would argue the result would be overfit, illegible, and impractical. This invites the idea of finding a better balance between the number of factors used for investment analysis and their explanatory power.
Applying Less-Is-More to Factor Investing
At Venn, we cut through the noise and analyze portfolios with just 18 factors that we believe are most important and unique across the investment universe. This creates a risk-based approach, which we call the Two Sigma Factor Lens, that looks beyond labels such as asset class and sector and instead identifies the common risks among them.
Starting from this fundamental factor lens, Venn then evaluates each investment with a two-step regression process that helps further whittle down which factors are most important. This results in a custom set of 18 or fewer factors used to explain each portfolio or manager. In our view, this less-is-more approach improves the interpretability of results and allows for a clear understanding of what is driving risk and return.
A Closer Look at Less-Is-More
Take, for example, Venn by Two Sigma factor analysis conducted on a mutual fund’s return stream.
- Step 1: Our statistical analysis first narrows our set of 18 fundamental risk factors down to 16 that are specific to this manager. In this example only our Credit and Small Cap Factors were removed.
- Step 2: Considering statistical significance and contribution to overall portfolio risk, we found only five factors were the primary drivers of risk and return for this fund (colored in teal below).
Factor Exposures (ß)
Source: Venn by Two Sigma, as of 10/31/2023. The chart displays factor analysis for an anonymous mutual fund viewed through the Two Sigma Factor Lens over a period of more than 5 years. For illustration purposes only.
Over a period of more than five years, our factor selection process revealed that four out of five of the most important factors for this manager were equity styles: Low Risk, Momentum, Value, and Crowding. At the same time, we can see this manager has virtually no exposure to Venn’s Equity Factor. This tells us the fund is likely designed to be market neutral, such that exposure in the long portfolio is offset by the short side.
More specifically, Venn’s analysis below reveals that 30.83% of this fund's risk has been driven by Venn’s Value Factor alone. This strongly suggests that Value may be an important consideration for this manager, especially when deciding whether or not they fit with your overall portfolio or market views.
Factor Contributions to Risk
Source: Venn by Two Sigma, as of 10/31/2023. The chart displays factor analysis for an anonymous mutual fund viewed through the Two Sigma Factor Lens over a period of more than 5 years. For illustration purposes only.
Simplifying How We Understand Investment Risk
We find that many in the investment industry still seek the most “accurate” answer by using hundreds or even thousands of factors to analyze their investments. We believe that conducting analysis with this many factors may not lead to accuracy, but rather overfitting and hard-to-interpret results. This, in turn, can leave capital allocators with more questions than they started with.
Venn cuts through two layers of noise. First, by identifying the 18 factors we believe are the most important to understand risk in the investment universe. And second, by identifying which of these factors we believe are the most important for each investment.
By explaining as much as possible with as little as possible, we believe results are more intuitive and actionable. On Venn, this factor analysis can be applied to any investment with a return stream including market neutral and multi-asset portfolios, providing what we view as holistic and clear results.
This post marks the second in a series on the four fundamental pillars of Venn (see below). Stay tuned for an upcoming post on another core pillar.
- Holistic, by capturing the large majority of cross-sectional and time-series risks 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 article is not an endorsement by Two Sigma Investor Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of the topics discussed. The views expressed above reflect those of the authors and are not necessarily the views of Two Sigma. This article (i) is only for informational and educational purposes, (ii) is not intended to provide, and should not be relied upon, for investment, accounting, legal or tax advice, and (iii) is not a recommendation as to any portfolio, allocation, strategy or investment. This article is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. This article is current as of the date of issuance (or any earlier date as referenced herein) and is subject to change without notice. The analytics or other services available on Venn change frequently and the content of this article should be expected to become outdated and less accurate over time. Any statements regarding planned or future development efforts for our existing or new products or services are not intended to be a promise or guarantee of future availability of products, services, or features. Such statements merely reflect our current plans. They are not intended to indicate when or how particular features will be offered or at what price. These planned or future development efforts may change without notice. Two Sigma has no obligation to update the article nor does Two Sigma make any express or implied warranties or representations as to its completeness or accuracy. This material uses some trademarks owned by entities other than Two Sigma purely for identification and comment as fair nominative use. That use does not imply any association with or endorsement of the other company by Two Sigma, or vice versa. See the end of the document for other important disclaimers and disclosures. Click here for other important disclaimers and disclosures.
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