The ROOF portfolios use the sector ROOF Scores to construct sentiment-tracking portfolios that capture the returns from a bullish or bearish strategy. The Risk-On and Risk-Off portfolios are constructed from the holdings of the STOXX® Europe 600 index and are rebalanced monthly (at month-end) using the then-current sector ROOF scores for the European market.
The first quarter of 2023 was a boomerang one for sentiment in Europe, starting the year very negative with a ROOF ratio -0.3 and bottoming out at -0.49 on Jan. 10, just above the bearish reading of -0.5. Hopes of a more dovish ECB lifted sentiment during the second half of January, with the ROOF ratio climbing for four consecutive weeks to reach a bullish level of 0.52 on Feb. 16. Although sentiment was not able to remain bullish for more than a single session, it maintained its strongly positive stance until March 10, when the banking crisis in the US and Switzerland weighed on sentiment and brought the ROOF ratio down to a neutral reading of 0.05 by March 15. Sentiment continued to decline even after the rescue efforts of the US Treasury department and the forced acquisition of Credit Suisse by rival UBS, ending the quarter in negative territory at -0.25, just above the level of -0.3 where it started the year.
Breaking down the numbers for the quarter
An improvement in investor sentiment is accompanied by a rise in demand for risk-tolerant assets as investors begin to implement a ‘risk-on’ strategy, which in turn drives up the price of those assets (the standard supply-and-demand economics are in play here). Conversely, when sentiment is weakening, the demand for risk-averse assets rises as more investors begin to implement a ‘risk-off’ strategy, driving up the price of those assets. When sentiment is neutral, the supply and demand for risk-tolerant and risk-averse assets is said to be at equilibrium, both being equally attractive to investors.
STOXX Europe 600 ROOF portfolios – Q1 2023
The chart above shows the cumulative return of the STOXX Europe 600 index (black line), the Risk-On portfolio (blue line) and the Risk-Off portfolio (green line), during the first quarter. The orange bars are the daily ROOF ratio values. Between Jan. 10 and Feb. 16, sentiment had been on the rise, driving up the demand for risk-tolerant assets. Investors remained strongly positive until March 10, when the banking crisis unfolded. The Risk-On portfolio outperformed the STOXX Europe 600 and its Risk-Off counterpart over that period. The banking crisis that followed caused investors to (temporarily) lose confidence in a very concentrated segment of the market – Financials. Financials happened to be not only the largest sector in the STOXX Europe 600 index, but its style factor exposures also make it one of the most risk-averse sectors in the ROOF methodology. As such, the Risk-Off portfolio is heavily overweight Financials (average active weight for the quarter is +8.9% and was +9.6% during the week of the banking crisis), while the Risk-On portfolio is very underweight the sector (see chart below). This explains why, despite the obvious risk-off market environment during the week of March 13-17, the Risk-Off portfolio underperformed both the Risk-On portfolio and the STOXX Europe 600 index.
Average sector weights during Q1 2023
By March 17, regulators on both sides of the Atlantic managed to instill some reassurance that a broader systemic banking crisis had been avoided, even as investor sentiment continued to decline, with the ROOF ratio dropping from 0.05 to -0.25 by the end of the month. Over this period, the STOXX Europe 600 recovered almost all its recent losses and ended the quarter just below its high-water mark. As sentiment continued to decline during the second half of March, the Risk-Off portfolio also recovered but not as fast as its two counterparts due to lingering concerns about the health of the banking sector. The Risk-On portfolio, with its small allocation to Financials (6.2% vs. 26.3% for the Risk-Off portfolio), managed to hold on to its earlier outperformance during this recovery period and ended the quarter well above the Risk-Off portfolio and just shy of the parent index (having lost more than the benchmark through the crisis).
During the 65 trading days of Q1 2023, investor sentiment was bullish (ROOF ratio >0.5) for a single day; positive (ROOF ratio between 0.2 and 0.5) on 31 days; neutral (ROOF ratio between 0.2 and -0.2) for 21 days; negative (ROOF ratio between -0.2 and -0.5) during only 12 days; and it was never bearish (ROOF ratio below -0.5). More importantly, sentiment was rising or remained high for 42 consecutive days during the quarter, before it declined to neutral and eventually became negative after the short-lived banking crisis. This prolonged period of greater demand for risk-tolerant assets over risk-averse ones helps explain the outperformance of the Risk-On portfolio over the Risk-Off variant during the quarter.
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As we wrote in our ROOF Portfolio recaps for 2021 and 2022, sentiment among European investors has been negative or bearish most of the time since February 2021, when inflation first rose its ugly head, forcing both the Bank of England (BoE) and the European Central Bank (ECB) to begin aggressively raising interest rates. In the two years since then, the Risk-Off portfolio has outperformed both its Risk-On counterpart and the STOXX Europe 600 parent benchmark. It is conceivable that large institutional investors with quarterly strategy review cycles would have maintained their defensive outlooks for Q1 2023.
The chart below shows the performance of three ‘defensive’ portfolios since January 2021 against the STOXX Europe 600 index (black line): The ROOF Risk-Off portfolio (green line), the constrained variant of the STOXX Europe 600 Minimum Variance index (purple line), and the unconstrained version of the STOXX Europe 600 Minimum Variance index (red line). For the 585 trading days of this period, investors were bearish on 159 days (28%), negative on 114 days (19%), neutral on 156 days (27%), positive on 96 days (16%), and bullish for only 60 days (10%). This means that investors were negative or outright bearish almost half the time, and positive or bullish only a quarter of the time. Given investors’ concerns about the impact of inflation on markets over the last two years, most would have implemented a risk-off strategy, driving up the demand for risk-averse assets. This is accurately captured by the outperformance of the Risk-Off portfolio since January 2021. This outperformance was even bigger prior to the March 2023 banking crisis, which, as mentioned earlier, affected the Risk-Off portfolio more than the other two portfolios due to its strong overweight in Financials.
STOXX Europe 600 Risk-Off portfolios vs. STOXX Europe 600 Min Var EUR GR (SAXPMVGR) and its unconstrained version (SAXPUNGR) – Jan 2021 to Mar 2023
Conclusion
The relative performance of the ROOF portfolios during the first quarter of 2023 was as expected. Looking at both the average ROOF ratio for the quarter (0.10), and the fact that investor sentiment rose continuously for two-thirds of the trading days during the period, the outperformance of the Risk-On portfolio over the Risk-Off one is not surprising. We note that the only risk-off event during the quarter was concentrated on a single sector, Financials. Financials has been a risk-off sector for the European market since 2017 and has been increasingly overweight in the Risk-Off portfolio since then. The combination of the March 10-17 banking crisis and the overweight of Financials hampered the ability of the Risk-Off portfolio to deliver its intended lower drawdown returns during this risk event. In times of crisis, the market does not reward risk-taking. It pays off to be risk averse.
We also saw that over the medium-term, risk events temporarily affecting a single sector will be mitigated by the overall alignment that the ROOF portfolios have with investor sentiment. Our contention is that sentiment is multifactorial, so its portfolio implementation should involve multiple factors in addition to Volatility1, and that market timing should not be part of the portfolio construction when trying to capture the sentiment risk premium. By broadening the definition of what it means — in terms of factor exposures — to be bullish or bearish, investors can construct a more efficient portfolio that better represents their investment thesis.
1 See the ROOF Portfolio methodology documentation for details.
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