Almost nothing is more unnerving to investors than the onset of a panic. Yet the fact is, emotion—investor sentiment—continually impacts risk and the overall practice of investing. It is also one of the least addressed “factors” in the investment process. Why? Because let’s face it: how can you possibly measure—and consistently track—the sentimental mindset of the investment community?
We sat down with Olivier d’Assier, Head of Applied Research for APAC, to discuss the development of Qontigo’s ROOF Scores and how these scores can be leveraged to drive enhanced portfolio performance.
1) You refer to the ROOF Scores as a “trackable investor sentiment indicator”. What exactly do you mean by that? And if markets are efficient, why do investors need to worry about trends in sentiment?
Markets are efficient because most investors use well established models to forecast the future values of equities, given a set of fundamentals as inputs. The problem is that efficiency depends on the accuracy of those fundamental inputs, and most of them are estimates and forecasts of economic growth, future earnings, etc. When uncertainty grows around those inputs, and the confidence interval of investor forecasts widens, sentiment, in the form of confirmation bias, can help fill the void and square the circle for investors.
For example, when uncertainty is high and sentiment is strong—either bullish or bearish—investors tend to overreact to news that confirms their bias, and underreact to news that does not. Knowing the prevailing sentiment in the market tells investors how others are likely to react to the daily news flow. A recent or sudden change in the direction of sentiment is equally important. After all, part of successful investing is about anticipating the anticipation of others.
The first step when thinking about investor sentiment is to stop thinking of the market as one thing. The stock market is made up of individual securities, each with its own risk-return profile. And while the market itself is sentiment neutral, there are pools of assets within it that reflect both risk-tolerant and a risk-averse characteristics. In essence, what is needed is a methodology to quantify and track the supply and demand for risk in the market, with the goal of measuring the net risk appetite at any given time. The fluctuations in this risk appetite are driven by investors’ forecasts of the rewards for risk-taking available in the market, and the key determinant for this forecast is confidence. When confidence drops and uncertainty widens the confidence intervals around this forecast, sentiment in the form of confirmation bias increasingly takes over the decision-making process for investors. And that is precisely when and why it becomes important to be able to measure and monitor investor sentiment.
2) A quick Google search on “stock market sentiment indicators” returns over 10 million entries, so clearly sentiment indicators have been around for a long time and are popular with investors. How is Qontigo’s sentiment indicator different? And why, with so many existing ones out there, did you choose to develop a new one?
Let me address that in two parts, first the “why”, then the “how”.
Some sentiment indicators are based on a single factor, like the Vix, the hi-lo ratio, or the yield on US Treasuries. Others use indicators from multiple asset classes to infer the sentiment of an ‘uber’ investor and apply this to all asset classes. Others use multiple economic indicators, such as retail sales, inflation, unemployment, etc., and mix them with a daily financial timeseries, like oil or gold prices. So, some are too narrow, some are too wide and require investors to have views across multiple asset classes. Back in 2018, our equity investor clients came to us with a simple request. Since we are a risk-management vendor and a factor shop, could we develop a methodology that enabled them to not only measure the overall sentiment across all investors in the equity market, but also to quantify their own portfolio’s sentiment, to see if they are aligned with either market consensus or with their own internal, possibly contrarian, views. So, the problem they were asking us to solve is one of relevance. They wanted to know not just how other investors in the market feel, but also to be able to construct a portfolio that reflects how they feel and ensure alignment with their own investment thesis. This is something existing sentiment indicators do not deliver, precisely because their methodology remains external to investors’ portfolio-construction process.
To fill the gap in the market, we developed our methodology taking a bottom-up approach that incorporates style factor returns as well as sector active return, both of which are observable quantifications of investor preferences. This methodology allows us to measure not only the aggregate sentiment in the market, but the implied sentiment of any client portfolios, too. We call this methodology the ROOF Scores, where ROOF is an acronym that stands for Risk-On/Risk-Off.
3) For most investors, sentiment indicators still feel like information that is—at a minimum—one degree away from actionable investment advice. After all, knowing how other investors around me “feel’” doesn’t specifically tell me what to buy or sell. How does Qontigo help clients incorporate its ROOF Scores into their investment process?
The advantage of using bottom-up daily stock data to construct the ROOF Scores is that we can use this same data to create indices that capture a risk-on or a risk-off strategy. Investors can use these as indices for performance measurement and attribution to track the return of their strategies. These indices can also be leveraged as overlays for either tactical asset allocation, or hedging, or as a sort of dynamic sentiment completion fund to ensure the total portfolio reflects the desired strategic sentiment profile.
The flexibility of the methodology—thanks to its bottom-up construction process and the use of daily data—also allows investors to tailor the ROOF scores to their investment horizon, or to rebuild them on their specific investment universe. This is a flexibility advantage unique to this methodology, and one that is not afforded by any other sentiment indicator we know of.
4) It sounds as if you have created a new factor called Sentiment. Have you been able to identify a new systematic factor return linked to sentiment?
I wouldn’t characterize sentiment as a new factor because investors have known about it for a long time. The issue is that until now these indicators have always been external to their investment process, which has made sentiment hard to capture via a portfolio, leaving index derivatives to fill the void. What is the use of identifying a new factor premium if investors cannot harvest it?
The ROOF portfolios can be thought of as multi-factor 2.0 in the sense that they rely on a factor view of the world through a sector allocation designed specifically to capture the level of reward in the market for both the risk-on and risk-off factor premia. The sector allocation dynamically adjusts to changes in the sector portfolio’s fundamental characteristics, so that as a sector becomes more or less risk-tolerant in style, its allocation in the risk-on and risk-off portfolios will be adjusted accordingly at each rebalancing. Beyond that, the stock selection within the sector allocations is constrained to ensure alignment with the style factor classification of the methodology. This is done to minimize the contribution to portfolio return from specific risk.
5) In summary, how should investors think about sentiment in their investment process?
What distinguishes sophisticated risk management from simple risk measurement is the deliberate decision to use risk as an input to the decision-making process, and not just an output for reporting. Sentiment, as a risk factor, should be treated the same way. Measuring portfolio sentiment and tracking it over time will only allow investors to reach their minimum goals of reporting and monitoring. If investors want to achieve the maximum goal of harvesting the sentiment risk premia, then they must treat sentiment as an input into the decision-making process.
This can be done as a portfolio overlay for tactical sentiment allocation, or to shrink alpha signals towards sentiment consensus. Alternatively, investors with a contrarian view can bet on sentiment directly via the individual ROOF portfolios. The key is that an investment process cannot be said to be sentiment-aware until it makes use of sentiment as an input for decision making which is only possible if sentiment becomes part of the portfolio construction workflow. And to reiterate, most other sentiment measures are ill-suited for this purpose.
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