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Blog Posts — January 6, 2023

2022 ROOF portfolios performance review: Risk aversion and sentiment alignment get rewarded for the second year in a row

The ROOF portfolios use the sector ROOF Scores to construct sentiment-tracking portfolios designed to capture the returns from the implementation of a bullish or bearish strategy. For the second year in a row, constructing portfolios aligned with the overall negative sentiment in the market generated significant outperformance relative to ‘holding’ the benchmark portfolio or adopting a contrarian bullish strategy. 

In the undeclared war between risk-tolerance and risk-aversion, there’s no question about which side won last year. That war is over. Years of hyper accommodative monetary policy turned the equity market into the investment equivalent of Coca-Cola, while all other asset classes battled it out to see who could become Pepsi. This all ended when fixed deposit rates rose from left field to become a true contender in the Pepsi challenge for the first times since the 90s. At 4.5% for a 3-month T-Bill, fear-of-missing-out (FOMO) is no longer a supporting factor for markets.

The investment environment in 2022 was made unusually difficult by increasing levels of macro and geopolitical uncertainty, both of which started from an already high base after rising during 2021 on inflation fears.  The combination of high market risk and high uncertainty increases the burden of proof on investors’ forecasts, especially when sentiment is bearish or negative, as it had been during most of 2021. Adopting a risk-on strategy at the start of 2022 can only be (politely) described as a bold contrarian bet.

Unfortunately, contrarians got it all wrong where it mattered in 2022, for the second year in a row. They were wrong about Russia not invading Ukraine. They were wrong about inflation having peaked in 2021. They were (repeatedly) wrong about central banks pivoting to their rescue. They were wrong about the pandemic being over. And they were wrong about cryptocurrencies. In the end, the performance of risk-on portfolios personified their own worst-case scenarios.

To quantify the rewards for risk-taking in the market, we use our sentiment indicator, the ROOF Scores, to construct both a risk-on and risk-off variant of the parent index1. The risk-on portfolio represents the implementation of a bullish strategy and is overweight sectors with a positive ROOF score (risk tolerant) and underweight sectors with a negative ROOF score (risk averse). Additionally, the within-sector stock selection ensures that the risk-on portfolio tilts on risk-tolerant style factors and away from risk-averse ones. The risk-off portfolio represents the implementation of a bearish strategy and is overweight sectors with a negative ROOF score (risk-averse) and underweight the ones with a positive ROOF score (risk-tolerant). We then measure the performance of each of the ROOF portfolios versus the parent index to quantify the rewards paid by the market to both types of investors.

The charts below represent the performance of our ROOF portfolios for the US market, built from the STOXX USA 500 parent index, and for the European market, built from the STOXX Europe 600 parent index, for 2022.

Figure 1: STOXX USA 500 ROOF portfolios – 2022

Source: Qontigo

The STOXX USA 500 index ended the year with a 20% loss. The Risk-Off portfolio fell by ‘only’ 13% during that period, while the Risk-On portfolio lost 23%. This means that in relative terms (i.e., active returns), the market ‘rewarded’ investors for constructing portfolios that were more risk-averse than the benchmark, and ‘punished’ those with the hubris of constructing portfolios that were more risk-tolerant than the consensus.

We also note that during the 252 trading days of 2022, the ROOF Ratio (orange bars on the chart) was in the bearish zone (below the red dotted line at -0.5 on the right axis) for 109 (43%) of those days, and in the negative zone (between 0 and -0.5) for another 100 (40%) days, meaning that investors were either negative or outright bearish 83% of the time last year; the very definition of a Risk-Off environment. Ignoring this negative sentiment and deliberately betting against those odds takes a particular type of contrarian…  

We replicated the same process for the European market, building both risk-on and a risk-off variants of the STOXX Europe 600 parent index and measuring their performance during 2022. The chart in figure 2 below shows the additional fear impact that the war in Ukraine had on European investors and the higher cost associated with ignoring that in Europe versus the US. The STOXX Europe 600 index ended the year with an almost 9% loss. The Risk-Off portfolio managed to recover all its losses by year-end, finishing flat for the year, while the Risk-On portfolio lost almost 27%. This means that in relative terms, the European market ‘rewarded’ its investors more than its US counterparts for constructing portfolios that were more risk-averse than the benchmark, and ‘punished’ those investors misguided enough to construct a more risk-tolerant portfolios more than the US market ‘punished’ its own bullish investors.

During the 258 trading days of the European market in 2022, the ROOF Ratio (orange bars on the chart) was in the bearish zone (below the red dotted line at -0.5 on the right axis) for 90 (35%) of those days, and in the negative zone (between 0 and -0.5) for another 101 (39%) days, meaning that investors were either negative or outright bearish 74% of the time; another very strong risk-off environment. And although European investors were less negative than US investors (judging by their respective ROOF Ratios), what matters from an investment perspective is the size of the rewards/punishment that the local market doles out to investors who take a contrarian stance to the overall sentiment. In Europe in 2022, it paid to follow the crowd, defiance was severely reprimanded.

Figure 2: STOXX Europe 600 ROOF portfolios – 2022

Source: Qontigo

Figure 3 displays the average sector allocations of the three US and European portfolios (Benchmark, Risk-On and Risk-Off). These allocations are based on the respective Sector ROOF Scores of each sector, which defines them as either risk-averse or risk-tolerant. The size of the overweight and underweight at each month-end rebalancing is driven by the then-current strength of the respective sector ROOF scores. The more positive the sector’s ROOF score, the more overweight it will be in the Risk-On portfolio, and the more underweight it will be in the Risk-Off portfolio. Conversely, the more negative the sector’s ROOF score, the more overweight it will be in the Risk-Off portfolio, and the more underweight it will be in the Risk-On portfolio. Note that these weights are pretty stable throughout the year; a sector that was risk-tolerant/risk-averse at the start of the year, was also risk-tolerant/risk-averse at the end.

Figure 3: Sector allocations – YTD 2022

Source: Qontigo

Summary and conclusions

2022 was another risk-off year for markets in the US and Europe (globally, in fact). Higher market risk translated into bigger returns for investors – both positive and negative – which in turn required a correspondingly higher degree of confidence in their investment thesis during a year of rising uncertainty levels from a decreasing macroeconomic and geopolitical predictability. Additionally, rising short-term interest rates gave investors a risk-free option to consider, resulting in lower average traded volumes after July. As a result, the demand for risk-averse assets increased all year, inflating their valuation at the expense of risk-tolerant ones, resulting in an outperformance for risk-off portfolios over both the parent benchmarks and, much more substantially, risk-on portfolios.

The decision to go against an overwhelmingly negative investor sentiment by taking on more risk than the market in 2022, can be viewed as either simple or confounding, depending on how long you want to think about it. The simple answer is hubris. The confounding part is trying to understand how betting against investor sentiment in your market 83% or 74% of the time, can seem more enlightened than the opposite.

A lookahead at 2023

As of this writing, investor sentiment has returned to neutral, a state where any misplaced emotional response to risk events dissolves into logic; a case of the outlier being viewed from the middle. Next stop, the Q4 2022 earnings reporting season. Maybe CEOs can help investors decide what’s in store for them in 2023.

Plenty of risk factors remain in play to keep uncertainty high, especially in the High-Yield bond market (e.g., Bed Bath & Beyond), and the potential contagious effect of a further rout in the Cryptocurrency market. On the geopolitical front, things do not look any clearer with regards to how or when the war in Ukraine will end, the future status of the US-China relationship, or the potential ongoing impact of new COVID-19 variants.

Last year saw investors price in higher interest rates and a slowing global economy in market valuations, but not the potential for (sharply) higher corporate defaults from the unprecedented rise in interest rates. This downside potential remains on the table for 2023. Bonds denominated in USD had their worst year in history (down 13%), yet corporate bankruptcies remain just off their historical lows2.

The key for investors is not the risk event itself, but the attitude of other investors towards the risk event. This is precisely what the ROOF score were designed to quantify daily. The ROOF portfolios simply measure the rewards an investor can earn by aligning their strategy with the sentimental consensus.


[1] The detailed portfolio construction methodology can be found here.

[2] See the Bloomberg Corp Bankruptcy Index.