Blog Posts — June 16, 2021

Beware of Positive Sentiment Driven by “Need”

Investors buy and sell stocks for one of two reasons: either because they want to or because they need to. In the world of portfolio construction, wants are driven by alpha signals and represent the exposures for generating excess returns. Needs, on the other hand, can be thought of as being driven by constraints and represent the exposures a portfolio must have to remain compliant, usually because they are part of the investment mandate. The biggest and most influential mandate constraint is the risk budget. For example, a manager may want to get a high exposure to growth, but an active risk constraint may force him or her to reduce or hedge that exposure to keep active risk below a certain level and remain compliant. Think of it as wanting that second brownie, but needing to fit into that new pair of jeans for the office Christmas party.

Qontigo’s ROOF Score methodology is designed to capture both motivational aspects of investment behavior. In the Style ROOF methodology, the eight fundamental style factor-based metrics help quantify what investors want to get exposure to, while the two risk-based metrics help quantify their need to de-risk or re-risk their portfolios by reducing,  hedging, or increasing those exposures. Similarly, in the Sector ROOF methodology, the 11 GICS sector-based metrics define what sectors investors want to buy or sell, and the two risk-based metrics capture why they need to buy or sell them.

Over time, market-moving events generate either more need or want for portfolio rebalancing. Using each metric’s contribution to the overall market ROOF scores, we can track the motivational nature of the aggregate market move each day (i.e., are they driven by want or need?). For example, the chart below shows the two drivers of sentiment (WANT in green, NEED in blue) for the US market year-to-date. We see that after the initial inflation tantrum in early February, investors gradually became more positive about investing as WANT became a larger part of the motivation, reaching a high of almost 80% in late April. Since then, the NEED motivator has been increasing and is now over 60% of the motivation behind market activity.

Using this decomposition of the ROOF Scores we can rebuild a ROOF Ratio for the US market that only represents the WANT part of the motivation and compare it with the aggregate ROOF Ratio. The chart below shows the aggregate Sector ROOF ratio (blue line) and the WANT ROOF Ratio (green line) for the US market year-to-date. We see that since about mid-May the ROOF ratio has started to improve from bearish (below -0.5) to the top half of the Neutral zone (-0.5 to +0.5) at +0.25. But looking at the WANT ROOF Ratio we see that after the initial rebound mid-May, sentiment plateaued near the bottom of the Neutral zone by May 24 and ended at -0.28 on June 11. The rise in the ROOF Ratio in the last two weeks was increasingly driven by NEED alone. Put another way, the positive sentiment you see may not be entirely genuine—and when NEED is in the driver’s seat, changes in sentiment happen more quickly and sharply than when WANT is at the wheel.

Why is this important? Need in our methodology is defined by the risk environment. As the predicted volatility of the US market declined towards pre-pandemic levels recently, the active risk of portfolios likely declined as well, forcing a need for some investors to increase their exposure to risk assets to remain compliant with their active-risk mandates. This may be why markets are still rising despite no changes in the fundamental situation and the next earnings season still being a month away.

That said, suppose volatility was to increase suddenly, because of some geopolitical event, a natural disaster, or simply for seasonal reasons due to the thin volumes during the summer months. This need to re-risk would then turn into a need to de-risk the portfolio. Need would remain the key driver of sentiment but would then push the ROOF Ratio in the opposite direction, towards risk aversion.

Depending on the nature of the risk event that triggered the higher volatility, and if this affected investors’ forecasts, the WANT part of sentiment may change, too. But that is less likely unless the risk event is seen as having a lasting directional implication, such as a change in monetary policy, which would then drive the WANT part of sentiment to rebalance exposures to more risk-averse sectors or styles as well (e.g., away from Growth and towards Value). 

In essence, you can think of the ROOF Ratio and the WANT ROOF Ratio as you do for CPI and Core CPI. The WANT ROOF Ratio is the core sentiment without the more volatile NEED component. As of June 11, 2021, the ‘core’ sentiment is materially weaker than the ROOF Ratio indicates. Given the upcoming summer months, investors may want to tread carefully and take the current seemingly positive sentiment momentum with a grain of salt.