The Latest from Two Sigma Research: Reverse Optimization

Estimating forward-looking asset class returns is an unavoidable necessity for investors constructing portfolios. What options do investors have for determining long-term return expectations? Differing asset definitions, data sets, and methodological details can result in a vast diversity of individual models and estimates, but most boil down to one of the following estimation archetypes:

1. Estimating long-run return premia from historical data, as done in our paper, Forecasting Factor Returns.
2. Building up forecasts from current valuations, combining estimates for sub-components of longer-term returns such as income and growth expectations.
3. Harnessing the wisdom of crowds, by surveying or estimating the average forward-looking views of market participants.

In a recent Street View, our colleagues on the Two Sigma Client Solutions Research team (the group responsible for developing new Venn factors and methodologies) delve into a particular quantitative example of the third method: harnessing the wisdom of crowds. By applying a tool called reverse optimization to the worldwide investable asset portfolio, we show how long-term factor and asset class returns can be estimated from the aggregated allocation decisions of all investors.

While this Street View applies the reverse optimization method to the global market portfolio in order to estimate aggregated global investor outlooks for different asset classes, another application of the technique is to apply it to your portfolio to back out implied views on factors or individual holdings. Comparing these implied views to other return estimation methods, such as long-term realized returns or investors’ capital market assumptions, could identify areas of misalignment between actual portfolio positioning and forward-looking return expectations.

The Venn team is looking at how we can bring this reverse optimization research into Venn. Get in touch with your Venn relationship manager to learn more. Not a Venn Pro user? Sign up for free to get access to features like reverse optimization today.

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