It’s been a bad few months for no-thought investing. In the second quarter, our low-risk portfolio (the 20 lowest-beta stocks) fell 1.3 per cent, under-performing the FTSE 350 by 2.6 percentage points: our value portfolio (the 20 highest yielders) fell 1.2 per cent; and our momentum portfolio (the 20 biggest risers in the year to March) lost 9 per cent.
The issue here is a big one. If it’s possible for simple portfolios based upon stock screens to beat the market then we don’t need to pay fund managers a fortune in the hope that they’ll do so. What’s at stake here, then, is nothing less than the justification for the existence of an entire industry. And if the last three months are any guide, there might be such a justification because no-thought investing doesn’t work.
| Performance of our no-thought portfolios | |||||
| in Q1 | Last 12 months | Last 3 years | Last 5 years | Last 7 years | |
| Momentum | -9.0 | 15.9 | 19.9 | 83.3 | 70.9 |
| Negative momentum | 0.3 | 11.1 | n/a | n/a | n/a |
| Value | -1.2 | 24.3 | 25.7 | 52.7 | -53.4 |
| High beta | -6.6 | 12.3 | 13.4 | 55.3 | -10.8 |
| Defensives | -1.3 | 4.0 | 23.6 | 67.5 | 24.1 |
| Megacaps | 1.9 | 5.5 | 2.9 | 43.9 | 1.9 |
| FTSE 350 | 1.3 | 9.3 | 15.8 | 65.0 | 5.9 |
| Price performance only: excludes dividends and dealing costs | |||||
But are they a guide?
It’s unlikely that this episode alone shows that no-thought investing is a daft idea. We have evidence going back as far as the 1920s in the US and from around the world over long periods that both momentum and defensive investing have beaten the market on average. From this perspective, it would be irrational to over-react to just three months of data.
This is especially the case as this under-performance might be just statistical noise. Take for example our momentum portfolio. Since we started it 10 years ago, it has had an annualised tracking error of 13.2 percentage points; this is the volatility of returns relative to the FTSE 350. This implies that even if momentum beats the market by five percentage points per year on average we should expect an underperformance of the sort we saw in Q2 in roughly 4.5 per cent of all three month periods. From this perspective, its under-performance has been unusual but not freakish. Every investment strategy, however good, suffers periods of losing money. Maybe this is just one.
There is, though, another possibility here. It’s that investing, like biology, sees population cycles.
If a species enjoys an increase in the availability of its food, it would increase in numbers. But these greater numbers would deplete the food source which would in turn cause the species to decline. As it declines, though, the food source grows back which eventually allows the species to multiply again. And so the cycle goes on.
The same thing happens in finance – the performance of small cap stocks, for example, has been cyclical in this sense since the 1980s. And perhaps we’ve seen it recently in momentum investing. If investors learned of the merits of momentum investing a few months ago they would have been converted to the strategy and so would have bid up the prices of momentum stocks. But this would have driven up their prices too far, with the result that they subsequently fell. An increase in the numbers of momentum investors depleted the food source (momentum profits). If this is the case then momentum investing should eventually enjoy an up-cycle again as disillusioned investors cease being momentum investors which would in turn cause momentum stocks to be under priced again. We can’t tell when this will happen. Perhaps it has done so already.
However, there’s another reason for the under-performance of our no-thought portfolios. It lies in the fact that our mega-cap portfolio – the 20 biggest stocks on the market – has done well; in the past three months, AstraZeneca, Royal Dutch and BG have all risen more than 10 per cent. Whenever this happens, market indices (which are weighted by market capitalisation) out-perform more equal-weighted portfolios such as our no-thought ones. Quite simply, a few good big stocks drag up the indices.
However, this weighting effect hasn’t just depressed the relative performance of our no-thought portfolios. It has also been bad for active managers generally too. The median fund in Morningstar’s large cap blend equity sector rose only 0.9 per cent in Q2. That’s less than the FTSE 350 and worse than many tracker funds. I suspect the gap would be greater were it not for the fact that many so-called actively managed funds are in fact partially closet trackers.
To this extent, the poor performance of our no-thought portfolios does not vindicate judgment-based investing with its high fees, but rather simple index tracker funds.
This poses the question: will mega-caps continue to outperform and so drag up tracker funds relative to more equal-weighted portfolios, be they no-thought screen-based ones or expensive judgment-based ones?
I’m not sure we can say for sure. Although history suggests that big stocks should outperform during times of rising interest rates, many of the other factors that influence their relative performance are unpredictable, such as changes in investors’ sentiment. My suspicion – based upon Gibrat’s law – is that mega caps should do about as well as other stocks on average over the very long run.
Herein, perhaps, lies a case for a form of core-satellite investing. A combination of a tracker fund plus momentum or defensive stocks can protect us from fluctuations in mega caps. If these do well then equal-weighted portfolios would underperform the market but a tracker fund would also do well. And if mega caps under-perform the market, trackers would be dragged down but there’s a good chance – based upon their long-run performance – that defensives or momentum would out-perform.
In this sense, there might be a place for passive investing alongside some no-thought strategies.
As for the circumstances in which judgment would systematically beat no-thought investing, this is another question.
Our new benchmark portfolios
Momentum (the 20 best performers in the last 12 months): GW Pharma, Green Dragon, Kentz, Optimal Payments, Shire, African Barrick, Centamin, Greencore, NMC Health, JD Sports, Hikma, ABF, Songbird Estates, BTG, Darty, Henderson, Hays, Vectura, Petra Diamonds, Amerisur.
Negative momentum (the 20 worst performers in the last 12 months): APR Energy, ASOS, Cairn Energy, Debenhams, Dominos Pizza, Gulf Keystone, Imagination Tech, Indus Gas, ITE, Ladbrokes, Lancashire, Ophir Energy, Partnership Assurance, Perform, Serco, Spirent, Telecity, Vodafone, William Hill, Wm Morrison.
Value (the 20 highest yielders): Amlin, Antofagasta, Balfour Beatty, Berkeley, Carillion, Catlin, Centrica, De La Rue, Friends Life, Icap, Intermediate Capital, J.Sainsbury, JD Sports, Ladbrokes, Phoenix, Redefine, SSE, Tullett Prebon, Vodafone, Wm Morrison.
High beta (the 20 highest beta stocks in the last five years): Afren, Amerisur, Antofagasta, Barratt Devs, Ferrexpo, Gulf Keystone, Inchcape, Int Cons Airlines, IPF, Ithaca Energy, Kazakhmys, Lamprell, Lonmin, Morgan Adv Mats, RBS, Regus, Thos Cook, Travis Perkins, Vedanta, Vesuvius.
Defensive (the 20 lowest beta stocks, subject to no more than three from one sector): Adv Comp Software, Betfair, Cranswick, De La Rue, Dechra, Dignity, Dominos Pizza, Drax, G4S, Green Dragon, James Halstead, Lancashire, Qinetiq, Randgold, Severn Trent, Synergy Health, Telecity, Telecom Plus, United Utilities, Vectura.
Megacaps (the 20 biggest stocks): AstraZeneca, Barclays, BAT, BG, BHP Billiton, BP, Diageo, Glaxo, Glencore, HSBC, Lloyds Banking, National Grid, Prudential, RBS, Reckitt Benckiser, Rio Tinto, Royal Dutch, SABMiller, Unilever, Vodafone
(All portfolios are drawn from shares with a market cap of £500m or more).
