Rev. Date September 22, 2022
What is residual?
One of Venn’s four core pillars is to be holistic. This means Venn seeks to explain a large majority of risk commonly found in portfolios, but it is often the case that there is at least some portion of return variation that is not explained by Venn’s Two Sigma Factor Lens. This unexplained portion of return is what Venn refers to as residual.
How is residual calculated and what does it represent?
Venn's regression process naturally breaks down the portfolio returns into components driven by factors, detailed here.
The residual captures the return or risk that is not explained by the linear factor model.
Given that it is a static conditional estimation (over the time period selected), it may be useful for investors to evaluate portfolio performance as the overall historical portfolio return that is not linearly explained by the chosen risk factors.
While it may depend on the type of asset or strategy being analyzed, in the case of active managers, all or some of this residual term may represent a measure of their effectiveness in generating returns not driven by Venn’s identified systematic risk. Note, some of the residual value may also be attributed to other or unknown factors.
Where can I see residual attribution?
For portfolios constructed on Venn, where underlying investments and weights are included, residual attribution is generated and displayed across several analyses:
Residual Factor Contributions to Risk - investment level contributions to total portfolio volatility, displayed as percentage contributions.
Residual Factor Contributions to Return - investment level contributions to total portfolio return, displayed as absolute marginal contributions.
Residual Performance Summary - investment level contributions to total portfolio residual return, total portfolio residual volatility, and total portfolio residual Sharpe ratio, each displayed as absolute marginal contributions.
What is Contribution to Residual Volatility and how is it calculated?
When evaluating the Contribution to Residual Volatility of a portfolio, it can help us to understand in what percentage each underlying investment’s residual risk contributes to the portfolio’s overall residual risk.
The portfolio-level residual is effectively the average of the underlying investments’ residuals weighted by capital allocated.
As a result, the contribution to residual volatility follows the same intuition of contribution to volatility (see here). The contribution to the portfolio residual volatility from one investment i, is proportional to (1) the weight of the investment i; (2) the residual vol of the investment i; and (3) the correlation between the residual of investment i with the portfolio residual.
Are there any known limitations to the calculation?
A general assumption is applied such that each investment-level residual return is uncorrelated.
This document highlights certain aspects of this feature. As an overview, it does not discuss all material facts or assumptions. Please see Important Disclosure and Disclaimer Information.