Public Investment Memorandum on Two Sigma Risk Premia Enhanced Fund, LP

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Recommendation

Staff, together with Aksia, recommends that PSERS invest $200 million in the Two Sigma Risk Premia Enhanced Fund, LP (Fund). This recommendation is based on our assessment of the investment strategy and our evaluation of Two Sigma Advisers, LP’s (Two Sigma) capabilities.

Firm Overview

Two Sigma Investments, LP (TSI) was co-founded in 2001 by John Overdeck and David Siegel (currently the co-Chairmen of Two Sigma). John and David, who worked together at D.E. Shaw & Co., both have significant experience in developing and managing a quantitative, model-driven approach to investment management. Two Sigma, an affiliate of TSI, was launched in 2009 as an investment advisor focused on institutional asset management. Two Sigma aims to generate uncorrelated returns in liquid global markets across a wide range of market conditions using a disciplined, systematic approach. Two Sigma’s systematic approach combines an experienced and diverse research & development team, large amounts of data, and world class computing power in an effort to create a sustainable advantage.

Market Opportunity / Investment Strategy

Investors are compensated for taking risks. An investor’s ability to identify and trade risk factor exposures (risk premias) in a systematic manner should generate positive performance over a longer time horizon. Risk premia strategies are different from traditional beta strategies that focus on asset class exposures and from alpha strategies that focus on idiosyncratic (or individual) risks. Instead, risk premia strategies focus on recognized, fundamental risks that have historically provided attractive risk-adjusted returns with low correlations to the markets and other absolute return strategies.

Two Sigma’s approach to risk premia is to build a diversified portfolio of long and short positions using a diverse set of longer-term fundamental and technical models from their common research platform. Fundamental models capture quantitative and qualitative information from publicly available data to assess value, quality, yield, and other measures. Technical models capture data such as price and volume to assess behavioral biases such as trend following. Rigorous testing and bottom-up analysis is performed on large quantities of data to create models that identify and profit from trading persistent relationships. A target portfolio is created using expected returns, anticipated trading costs, and risks in a systematic way. Using proprietary technology, a dedicated execution team utilizes trading strategies to adjust the current portfolio to the optimal portfolio. Ongoing research is performed to improve performance under different market environments.

Capital will be split 70/30 between equity strategies and macro strategies. This capital allocation results in a 60/40 risk allocation between equity strategies and macro strategies. The equity portfolio is a long/short market neutral portfolio seeking to avoid exposure to general equity market risk. The macro portfolio will be a long/short directional portfolio that will trade based on the investment manager’s assessment of various asset classes and financial instruments around the world.

Portfolio Fit

The investment in the Fund will be part of the Absolute Return Program.

Investment Instruments

The Fund will invest in equities (including single name equities and exchange traded index products), derivatives, forwards, futures, fixed income securities, and currency contracts.

Investment Team

Geoff Duncombe will serve as the portfolio manager on the Fund. Geoff joined Two Sigma in 2008 and has worked in the investment industry since 2001. Geoff is supported by over 650 professionals that work on the Research & Development team. This team is responsible for data gathering and cleaning, research and modeling, forecasting, portfolio construction and optimization, order execution, risk management, and portfolio analysis.

Investment Highlights

  • Track Record: Two Sigma has a long track record of successfully launching and managing quantitative, model-based investment strategies. In addition, the investment manager has been disciplined in closing funds whose underlying investment strategies have reached capacity so that the funds do not grow too large and negatively impact performance.
  • Human Capital: Two Sigma employs over 1,100 professionals with over 650 professionals in Research & Development. Many professionals come from outside the finance industry with advanced degrees in mathematics and science. These diverse backgrounds give the firm the feel of a technology company which promotes the innovative use of technology and scientific methods in the finance industry.
  • Infrastructure:Two Sigma has world class computing power that would rank the firm among the top supercomputing sites in the world. This computing power is used to gather, clean, analyze, and warehouse large amounts of data from external sources.

Investment / Risk Considerations

  • Modeling and Market Dynamics: The Fund uses quantitative models that rely on patterns inferred from historical data to evaluate prospective investments. Sudden unanticipated changes in underlying market conditions could impact the performance of the Fund. In addition, market dynamics change over time and a previously successful model could become less effective or outdated.
  • Reliance on Technology: All aspects of the investment program (data gathering, research, forecasting, portfolio construction, order execution, risk management, and all back office functions) are dependent on technology and proprietary software. The investment manager has numerous safeguards in place to detect and prevent any coding errors, technology malfunctions, or security breaches.
  • Reliance on Data: The investment strategies rely on gathering, cleaning, and analyzing large amounts of data from external sources. The manager will use its discretion to determine what data to gather and use in their models. There is no guarantee that the data used is the most accurate data available or is free of errors.
  • Market Environment: Many of the trading strategies make assumptions about the continuation of the current market environment. The strategies assume that past behavior can be used to predict the future. There are no guarantees that relationships that govern securities and their prices in the past will continue in the future.
  • Track Record: Two Sigma has a limited live track record with this investment strategy. While actual performance since inception in August 2015 has been in line with the projections, there is no guarantee that the actual performance will continue to match the expected performance.
  • Human Capital: Staffing levels have grown by over 10% each year since 2010. Given the projected staffing growth, there is a risk that Two Sigma will not maintain the culture that has generated the current set of quantitative, model-based investment strategies.
  • Assets Under Management: Assets under management have grown by over 10% each year since 2010. In the past, the investment manager has been disciplined in closing funds whose underlying investment strategies have reached capacity so that the funds do not grow too large and negatively impact performance. There is no guarantee that the investment manager will continue with that discipline in the future.
  • Transparency: Two Sigma’s approach to portfolio construction is to build a diversified portfolio of long and short positions using a diverse set of longer-term fundamental and technical models. As an investor, there is limited transparency into the models, how the models are assembled to construct a portfolio, or individual portfolio holdings.

Finance Committee Disclosure

  • Relationship with Aksia: None Disclosed
  • Introduction Source: Aksia
  • Placement Agent: None Used
  • PA Political Contributions: None Disclosed
  • Potential Conflicts: We are not aware of Two Sigma having any material investment conflicts.
  • PSERS History with the Investment Manager: This investment will be PSERS’ first investment with the manager.
  • PSERS Allocation Implementation Committee Approval: November 18, 2016

Oversight Responsibility

  • Investment Office: Charles J. Spiller Deputy CIO, Non-Traditional Investments; Robert E. Little Senior Portfolio Manager
  • External Consultant: Aksia LLC

Source: Robert E. Little, Commonwealth of Pennsylvania Public School Employees’ Retirement System