Sentiment in 2021 can be summed-up in one word: “concerned”. Generally speaking, investors know there are only a handful of events that can spark a turning point in a market cycle—and in 2021 most expected tapering to be one of them. In fact, this was a year when investors rediscovered that macro factors matter after all — every surge in consumer demand, every energy price increase, every supply-chain bottleneck, every wage hike, every delayed monetary response — all of it.
The STOXX USA 500 rose 26% in 2021. Yet constantly betting against its continued rise was the best way to outperform it. This may at first seem jarringly counterintuitive and provoke much rational resistance. After all, conventional investment wisdom dictates that the best way to outperform a rising market — one that is rewarding risk-taking — is by taking on more and more risk.
But the opposite was true in 2021, and restraint was rewarded instead.
Out of 252 trading days last year, investors felt cautiously optimistic about the strength and longevity of the global economic recovery on 49 (19%) of those days, and outright bullish for only six (2%) of them. Conversely, while they were concerned about rising inflation and its potentially detrimental impact on corporate earnings and the economy, they trusted that the Fed would get it under control on a total of 118 (47%) days, and were outright bearish that the Fed might be too dovish on 79 (31%) days. Incorporating these sentiments into one’s portfolio-construction decisions paid-off in 2021. Ignoring them, did not.
The chart below shows the cumulative returns for the STOXX USA 500 benchmark (black line), the US Risk-On ROOF portfolio (blue line), and the US Risk-Off ROOF portfolio (green line) for 2021. In a year when inflation concerns sent the US ROOF ratio into negative territory 78% of the time (orange bars in the chart below), the Risk-Off portfolio outperformed both the STOXX USA 500 (by 3% for the year, rising 29% versus 26% for the benchmark) and its Risk-On counterpart by 12% (29% vs. 17%).
The popularity of Risk-Off strategies in 2021 is revealed by looking at the Active ROOF Scores for a long-only Momentum factor portfolio against the STOXX USA 900 Index. Price momentum can be either bullish or bearish, depending on which types of stocks are currently in favor. Essentially, the performance of the Momentum factor alone does not tell us much about the type of strategy implementation gaining popularity with investors and driving price momentum, (i.e., are risk-averse or risk-tolerant strategies becoming more popular with investors?).
The chart below shows that for 2021, Momentum was never driven by bullish sentiment. The initial inflation tantrum at the start of the year made risk-averse strategy implementation increasingly popular with investors, driving its Active ROOF Score deep into negative territory between February and June (i.e., the increasing popularity of risk-averse strategies drove price momentum). Investors became less bearish in the second half, but remained more uneasy about inflation and risk-taking in general than the benchmark (i.e., risk-averse strategies remained more popular than risk-tolerant ones). Price momentum remained driven mostly by risk aversion in the second half (i.e., its active ROOF score remained negative), ending the year significantly more risk averse than the benchmark, reflecting a resurgence of risk aversion among investors in the last month of 2021.
In 2021, the return of macro concerns kept most investors on the defensive, increasing the popularity of risk-off strategies, as confirmed by the negative active ROOF score of the Momentum portfolio. These concerns diminished in Q3 but rebounded in Q4, giving another boost to the performance of our Risk-Off portfolio (especially in December). For the full year, aligning your strategy implementation with the prevailing risk-averse sentiment was the best way to outperform both the index and your more risk-tolerant peers. In short, 2021 was the year of the skeptics and the Fed-doubters. Investors who put their confidence in the Fed and implemented a risk-tolerant strategy suffered a 10% under-performance.
Also note that this was not an isolated incident; we saw a similar performance in the European ROOF portfolios (see chart below). So not happenstance, and certainly not double happenstance.
In conclusion, by quantifying investor sentiment in the market, Qontigo’s ROOF Scores can be used not only to construct portfolios representing the implementation of both Risk-On and Risk-Off strategies, but to track their performance versus the underlying benchmark. These ROOF Portfolios help us to measure the potential rewards for risk-taking in the market at any point in time (i.e., is risk tolerance or risk aversion being rewarded by the market?), which can help inform an investor’s risk-budgeting process. We can also use the ROOF Score methodology to identify the type of strategy implementation implied by any portfolio’s active exposures. This enables both portfolio managers and their investors to confirm alignment between the risk budget and the stated investment thesis.
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