One overlooked reason for this under-performance is that Aim stocks are especially sensitive to investors’ sentiment; when investors get depressed or nervous, Aim under-performs the main market. And, of course, sentiment has been weakening for a while now.
One indicator of Aim's sensitivity to sentiment is that annual returns on Aim shares relative to the All-share index are positively correlated with foreign buying of US equities. A 12 month period in which global investors pile into US stocks tends to be a period when Aim out-performs.
Also, Aim tends to beat frontline stocks when UK retail investors are heavy buyers of unit trusts.
The two best periods for Aim shares, relative to the All-share index, came in 1999-00 and 2009-10. Both coincided with big buying of unit trusts and big foreign buying of US stocks.
This is not because unit trusts invest heavily in Aim stocks or because global investors buy Aim shares whilst they buy US ones. Instead, it's because the periods when retail investors are buying unit trusts and global investors are buying US shares are periods when sentiment is high - when investors are happy to take on risk. And such high confidence benefits speculative stocks such as Aim ones by more than it helps the main market.
All this is consistent with what Malcolm Baker and Jeffrey Wurgler, two US economists, have found for US shares. They say: "Stocks of low capitalization, younger, unprofitable, high-volatility, non-dividend paying, growth companies or stocks of firms in financial distress are likely to be disproportionately sensitive to broad waves of investor sentiment." Such stocks are more likely to be found on Aim than on the main market.
You might think there'd be another indicator of Aim's sensitivity to sentiment - that Aim stocks have a high beta with respect to the All-share. In fact, they don't. Since 1997, the beta of Aim's monthly returns has only been around one, implying that good times for the All-share are not, on average, associated with stellar returns on Aim. This implies that positive sentiment towards Aim stocks is not the same as appetite for equity risk generally. This could be because Aim stocks offer lots of idiosyncratic risk, rather than market risk.
There is another sense in which Aim shares are swayed by sentiment. It lies in the ratio of the Aim index to the All-share index. There’s a strong correlation between this ratio and subsequent returns on Aim relative to the All-share – of minus 0.45 since January 1997. When the Aim index is high relative to the All-share, Aim tends to under-perform the All-share in the following 12 months. And when Aim is low relative to the All-share, it tends subsequently to out-perform.
This is not because of anything the All-share index does. The correlation between the Aim/All-share ratio and subsequent annual moves in the All-share index is almost zero. Instead, it is because the ratio predicts moves in Aim shares.
This is evidence that Aim stocks, more than mainline ones, tend to over-react. In good times, they get too high and subsequently fall. And in bad times they fall too far and so subsequently bounce back. This is consistent with them being driven by sentiment. Investors are prone to projection bias; they fail to foresee that their present taste for risk will change, and so in good times they don’t anticipate sentiment dropping and in bad times they don’t anticipate it improving.
All of this offers both good and bad news for investors in Aim stocks.
The bad news is that your efforts to research individual stocks are, if not wasted, then at least insufficient. If sentiment turns bad then even decent stocks might suffer, while if sentiment improves, some dross would benefit. You should look not just at shares' "fundamentals" but also at the state of sentiment.
And here's the good news. Aim is now very low relative to the All-share index – at its lowest since the spring of 2009. This suggests that sentiment is unusually depressed - a possibility corroborated by the relatively weak foreign buying of US equities in recent months. And this in turn suggests that Aim stocks might be now be under-priced. If so, the brave investor, who's prepared to buy when others are not, might be able to pick up a few bargains.
