How, then, should we invest in emerging markets? One possibility is to be a simple passive investor, holding a basket of them weighted by market capitalisation. But there's another possibility - to be a momentum investor. Historically, momentum investing in emerging markets has paid off wonderfully.
To establish this, I ran a simple test. I took the 21 emerging markets for which MSCI has data since 1994 and asked: what would have happened if we had bought an equal-weighted basket of the six best-performing markets in the previous six months, held them for six months, and repeated the exercise every June and December?
The answer surprised me. $100 invested in this portfolio would have grown by now to just under $781. That's an annual return of 11.4 per cent per year. $100 left in MSCI's emerging market index would have grown to just $207.
Momentum investing, therefore, works fantastically well. Curiously, though, it is only positive momentum that does well. Buying negative momentum (the six worst-performing markets) would have only slightly underperformed the emerging market index since 1994; such a portfolio would have grown to $200 by now.
This outperformance has not been a reward merely for taking on extra risk. The positive momentum strategy has been only slightly more volatile than the emerging market index - with an annualised standard deviation of 32.4 percentage points against 26.7 percentage points - and has had a beta with respect to emerging markets of 1.07. Neither of these figures would suffice to justify annual returns of more than double those of emerging markets.
However, the performance of momentum during the two great falls of the last 20 years has been very different. Momentum investing largely avoided the emerging markets slump of 1997-98 because it got us out of Asian markets just before they crashed. However, the strategy underperformed emerging markets in 2008. This might tell us that momentum investing carries liquidity risk: it does badly when investors scramble to raise cash.
Sadly, though, there's a problem here. It's that the fantastic success of momentum investing might be a thing of the past. Since the end of 2012, momentum has done only marginally better than a passive investment in emerging markets, losing 5.8 per cent against emerging markets' 7.4 per cent loss (in dollar terms). You can read this in one of three ways.
One possibility is that it is just plain noise. Momentum hasn't actually worked very often in the last 20 years. It has beaten emerging markets in only 21 of the 38 completed six-month periods in our sample: its success has been because outperformance, when it happened, has been large while underperformance has been small. This warns us to expect many periods of small outperformance.
A second possibility is that investors wised up to momentum investing a few months ago and in doing so bid away its profits.
A third possibility is that the disappearance of momentum profits is only temporary. Evolutionary market theory tells us that strategies are cyclical. A lack of profits drives momentum investors out of the market, but this means that profits eventually return for the remaining momentum investors. The success of strategies (not just momentum) waxes and wanes like population cycles.
What’s consistent with this possibility is that momentum investing has done okay since June. The momentum investor would have gotten into Indonesia and Thailand back then, and so bought two of the few markets to have risen recently. And he would have dumped Russia, Hungary and Chile and so avoided double-digit falls.
This decent performance suggests momentum investing is returning to profit, as evolutionary market theory predicts.
You might object here that such a strategy isn't feasible for retail investors. Maybe not - although this only shows that there isn't sufficient variety of financial products. Nevertheless, there are two important implications here.
One is that this is yet more evidence that momentum investing generally works. Clifford Asness at AQR Capital Management has shown that it succeeds over long periods and in commodities as well as equities. And Victoria Dobrynskaya at the London School of Economics has shown that it works around the world. We have here yet more corroboration of this. This should increase our confidence that momentum investing in UK equities is a viable strategy.
Secondly, this suggests that international asset allocation hasn't required much talent. 'Just buy what's gone up' has worked remarkably well. Fund managers' claims that they should charge big fees because they have rare expertise are, therefore, dubious.
