Sentiment as a Systematic Factor: Introducing Qontigo’s ROOF™ Market Portfolios
Over the past two years, Qontigo’s Applied Research team has released two variants of its sentiment indicator called the ROOFTM Scores. One is based on style factor returns, the other on a combination of style factor exposures and sector portfolio returns; we refer to them as Style-ROOF and Sector-ROOF. Starting in June 2019, we used the ROOF Scores as the basis of a weekly market commentary known as the Weekly ROOF Highlights. In addition, you will find many posts on our blog that make use of the ROOF Scores to analyze investors’ responses to various risk events. All resources for the ROOF Scores can be accessed here.
The supply and demand for risk is inherently influenced by sentiment. A strongly positive sentiment in aggregate results in a higher demand for risk than supply, and vice-versa. Continuing this line of thought, we see sentiment as a kind of mean-reverting systematic factor that should be rewarded when timed right, much like Size, Liquidity, or the Leverage factors in our fundamental factor risk models.
The basis of the ROOF Score methodology is that risk-tolerant and risk-averse investors seek opposing exposures to eight of our style factors. Using this information, we classify sectors as being either risk-tolerant or risk-averse, based on their exposures to these style factors. We then designed a methodology to construct two portfolios—Risk-On and Risk-Off—each capturing the sector and style exposures of their respective risk appetite.
Additionally, this methodology ensures that the magnitude of these exposures is dynamically proportional to the relative strengths of those two sentiments, as measured by the Qontigo ROOF Scores. The more bullish or bearish investors are, the stronger these sector and style exposures become, and vice-versa.
The portfolios’ performance will be dictated by the dominant sentiment at the time, which will trigger a supply-and-demand imbalance for risk in the market, driving investors towards one and away from the other.
The ROOF methodology defines what risk tolerance and risk aversion ‘look’ like in terms of factor exposures. The new ROOF Market Portfolios construction methodology will allow investors to design Risk-On and Risk-Off portfolios for their respective investment universes and to monitor their performance in both market environments.
Used in conjunction with the ROOF Scores, the ROOF Market Portfolios can form the basis of a sentiment-aware active strategy. Active return will then come in the form of either premiums obtained from those wishing to acquire the desired exposures, or discounts from those wishing to dispose of the unwanted ones, and will be based on the supply and demand for risk (i.e., the number of risk-averse versus risk-tolerant investors) in the market at that time.
For example, if the ROOF ratio is above +0.5, i.e., in the bullish zone, this tells us that there are more risk-tolerant investors in the market than risk-averse ones. If better-than expected news comes out, this net positive confirmation bias will be triggered into action. The minority risk-averse investors in the market—assuming they remain risk-averse after that news—will be able to extract a premium for their ‘risk-on’ assets from the majority of risk-tolerant ones wanting to buy more of them, and will be able to acquire more ‘risk-off’ assets at a discount from the many risk-tolerant investors wanting to sell them.
Conversely, when the ROOF ratio is below -0.5, i.e., in the bearish zone, this tells us that there are more risk-averse investors than risk-tolerant ones in the market at that time. If worse-than-expected news is released, this confirmation bias will be triggered into action. The minority risk-tolerant investors will now be able to extract a discount for ‘risk-on’ assets and a premium for ‘risk-off’ assets from the majority risk-averse investors.
Sentiment is a mean-reverting factor. Over time, investors may go from being bullish, to being neutral, to being bearish, and back again. The Risk-On and Risk-Off portfolio methodology provides investors with a rebalancing target in each case to ensure that they always remain sentiment-aware. Since their introduction, ROOF scores have proven to be a useful tool for managers looking to understand the current risk environment in the context of investor sentiment. Qontigo’s ROOF Market Portfolios take that value one important step further by providing a score-based sentiment-timing active strategy that can be used to invest in, or hedge against, sentiment.
For more information on the ROOF Market Portfolios, read our white paper, “Introducing ROOFTM Market Portfolios: Capitalizing on the Mood Swings of Markets?”.