by Olivier d'Assier
Last year we introduced the Qontigo ROOF Scores as a market sentiment indicator. The scores map our fundamental risk model’s style factors to either a risk-tolerant or risk-averse strategy. By monitoring which strategy was in favor with investors, we quantified the level of risk appetite in the market (a.k.a. ROOF Scores). Recently it occurred to us, probably out of hubris, that a similar indicator could be derived using sectors. We could characterize each sector based on its exposure to the style factors in the original methodology and map each sector to a risk-tolerant or risk-averse strategy. We could then use each sector’s active return against the market as a measure of each strategy’s popularity with investors and, therefore, the collective risk appetite.
The first step involved defining each sector’s ‘personality’ as either risk tolerant or risk averse by creating 11 cap-weighted sector portfolios using the GICS 2018 classification from a broad investible market universe and monitoring their style factor exposures using our fundamental factor risk model. A risk-tolerant sector is defined as one with a positive exposure to the following style factors: Growth, Leverage, Market Sensitivity, and Volatility. It also has a negative exposure to the following factors: Dividend Yield, Profitability, Size, and Value. Conversely, a risk-averse sector is defined as one with a positive exposure to the following style factors: Dividend Yield, Profitability, Size, and Value. It also has a negative exposure to the following style factors: Growth, Leverage, Market Sensitivity, and Volatility.
The second step involved determining each sector’s ‘popularity’ with investors each day by taking its active return versus the broad investible market portfolio (i.e., did investors favor risk-tolerant or risk-averse sectors today?).
In step three, we combine ‘personality’ and ‘popularity’ to compute the aggregate market ROOF Score. In other words, if risk-tolerant sectors were more ‘popular’ than risk-averse ones today, investors must have been more risk tolerant in aggregate. And vice-versa for risk-averse sectors. A detailed methodology document can be downloaded from the Qontigo website here.
In the chart below, the black line is the cumulative return of the US All-Caps market portfolio (i.e., AXUS-LMS). The blue line is the original style-based ROOF Ratio, and the orange line is the new sector-based ROOF Ratio. The correlation between the two ROOF Ratios is 0.80 during the period. We can also see that while the two lines were overlapping each other in October and most of November 2019, the Sector ROOF Ratio became less bullish than its Style counterpart since late November and has been more bearish since late January. Neither indicator gave the February market rally any credibility though, which should have been a warning sign. Both indicators are now in unsupportive territory (i.e., <-0.5).
US-LMS Cumulative Return (Black Line), Style ROOF Ratio (Blue Line), Sector ROOF Ratio (Orange Line) From: 10/1/2019 To 3/6/2020
Given the chart above, a natural question is, if both ROOF Ratios are so similar (correlation = 0.80 in the last eight years), why bother developing a new one? The answer is twofold. First, many of our clients do not think in terms of style risk premia and have investment strategies that are based on a sector view of the world. The scatter plot below maps the 11 US sectors and the aggregate US-All caps market portfolio in terms of their Risk Aversion (X-axis) and their Risk Tolerance (Y-axis) sub-score as of March 6, 2020. Intuitively, we see that Consumer Discretionary and Consumer Staples are at opposite ends of the risk appetite spectrum. Industrials, Technology, and Materials are well aligned with their cyclical qualities in the risk-tolerant quadrant. Telecommunication Services, Real Estate, Utilities, and Energy have a risk-averse mapping that is also in line with their defensive qualities. Two sectors that might seem out of place in this chart are Health Care and Financials. Historically, these may have been expected to be on the opposite side from this mapping. This brings us to the second value in developing sector-based ROOF Scores.
The ‘personality’ of each sector may not be constant through time and aligning active sector allocation bets with their then-current ‘personality’ will ensure that the portfolio manager’s investment thesis is correctly reflected in the active sector bets during the portfolio-construction phase.
For example, the Health Care sector started as a risk-averse sector prior to 2014, then became increasingly risk-tolerant between 2014-2016, and has been slowly declining in risk tolerance ever since, but remains on the risk-tolerant side (see chart below). A portfolio manager implementing a risk-averse strategy today would be ill-advised to over-weight the HC sector to reflect his bearish stance.
This change in personality reflects the changing scope of this sector and the associated changes in style factor exposures it experienced over the last eight-year period. The sector went from being a provider of health services to include a lot of smaller biotech stocks and slowly morph into a manufacturer of heath care products and services. During the eight-year period the sector saw a 30% increase in the number of constituents. Its exposure to the market sensitivity factor went from -0.33 pre-2013 to +0.44 in 2015 and back down again post-2015. Then back up, then down, etc. (see below).
Other than Consumer Discretionary, Consumer Staples, and Utilities, all other US sectors have had multiple personalities through time, either switching sides, or simply becoming more or less risk-tolerant/risk averse. Using a fundamental factor risk model, investors can monitor each sector’s changing personality and adjust their allocation to ensure alignment with their investment thesis.
The goal of any portfolio-construction process is to translate an investment thesis into a set of aligned exposures to risk factors. With this sector-based variant of the Qontigo ROOF Scores, we hope to make this task more transparent for portfolio managers, who allocate across sectors rather than styles, and bridge the gap between their allocation and investor sentiment.
You can find more detail on this variant of our ROOF scores here.
