Unthinking investing

No-thought value and momentum strategies have beaten the market handsomely in recent years

January 8, 2015

Last year was a decent year for value investors. A simple strategy of buying the 20 highest-yielding stocks with a market capitalisation of more than £500m at the end of each quarter would have made 4.1 per cent before dividends and dealing costs. That compares with a 2.2 per cent drop in the FTSE 350.

This continues a trend. In the past three years our no-thought value portfolio has risen by 63 per cent (even excluding dividends), which means it has outperformed most UK all company unit trusts.

You might infer from this that most fund managers' research and 'expertise' is wasted. All you've had to do to beat the market in recent years has been simply to look at a stock's dividend yield.

Such an inference would, however, be a little harsh. Value's outperformance has only come since the recession. In 2007-09, value stocks did catastrophically badly with some, such as Northern Rock and Bradford & Bingley, being wiped out totally.

Benchmark portfolio performance
	In Q4	In 2014	Last 3 years	Last 5 years	Last 7 years
Momentum	4.4	-6.4	39.7	64.3	81.5
Neg. momentum	-7.7	-13.2	-8.1	na	na
Value	7.0	4.1	63.0	29.8	-51.9
High beta	-4.6	-21.2	28.3	10.6	-15.0
Low risk	-1.7	-3.8	19.5	34.6	20.2
Mega caps	-2.3	-3.3	12.7	11.0	9.4
FTSE 350	-0.4	-2.2	22.9	27.9	9.4
Price performance only: excludes dividends and dealing costs

This pattern is consistent with the fact that value stocks carry cyclical risk. They tend to do badly in recessions and well in recoveries: last year, our value portfolio was overweight in cyclical retailers and construction stocks. And because the last three years have seen decent economic growth and a falling risk of recession, so value stocks have outperformed.

The danger for them is that this might not continue in 2015. If a post-election fiscal and monetary tightening depresses growth, cyclicals and value stocks might suffer.

This, though, is not the only danger they face. Just ask: why should a stock have a higher yield than another? Why don't investors buy high-yielding shares and so bid up their prices to such a high level as to equalise yields? The answer can only be that they believe a high yield is offset by some disadvantage. Sometimes, that disadvantage is additional risk such as extra cyclical exposure. In other cases it is because they are thought to offer lower growth. However, corporate growth is largely unpredictable. And this is a two-edged sword for value investors. The good news is that it means that investors can easily be too pessimistic about growth, with the result that value stocks deliver nice surprises. The bad news, however, is that underreaction might cause investors to be insufficiently pessimistic. To this extent, value stocks might do badly for the same reason that negative momentum stocks do badly.

Our other no-thought portfolios didn't fare so well in 2014. Momentum investing - simply buying the 20 best-performing shares in the previous year - lost 6.4 per cent.

This does not, however, mean there has been no momentum in shares. Negative momentum stocks - the 20 worst performers in the previous 12 months - did even worse. Although past winners didn't continue to rise, past losers did continue to fall. This is consistent with investors underreacting to bad news, with the result that shares suffering from it stay overpriced in the short run and so subsequently drift down. One reason for this might be that some investors cannot short-sell stocks which means that they don't immediately push share prices down sufficiently, with the result that they gradually drift down instead.

Thanks to the bad performance of negative momentum, a momentum strategy consisting of going long of positive momentum and short of negative momentum would have been profitable last year, making 6.8 per cent before dealing costs.

What's more, in the long-run long-only momentum investing has paid off. Despite last year's drop, our momentum portfolio has risen by 64.3 per cent in the last five years - double the gain of the FTSE 350.

It's not obvious that 2014's loss was due to investors wising up to the benefits of momentum investing and so bidding the excess profits away. If this were the case, we'd have seen consistent poor performance throughout the year. But we didn't. Momentum actually did well in the fourth quarter.

This is consistent with the adaptive markets hypothesis devised by MIT's Andrew Lo. This says that investment strategies are not permanently successful but rather wax and wane in a way analogous to population cycles in biology. If investors see a source of profits such as momentum stocks being underpriced, they will buy momentum just as a species will multiply if it discovers an abundant food source. This, though, will cause the food source (profits from momentum investing) to become less abundant. As this happens, momentum investing will become less popular - the species will decline - until eventually the food source becomes replenished and so profits from momentum investing return. This could be what happened late last year.

Whether this will continue to be the case is hard to say. Whereas population cycles in biology sometimes have a regular periodicity, those in financial markets do not. In some respects, the social sciences - and investing is merely applied social science - are harder than the natural sciences.

But momentum was not the only once-successful strategy to have had a poor 2014. Our low-risk portfolio also underperformed slightly, despite the fact that in theory low-beta stocks should outperform a falling market. And unlike momentum, low-risk shares did not return to favour at the end of the year.

We can't say whether this underperformance is because investors have wised up to the merits of defensive investing. My hunch (and it's only that) is that this isn't the case. Defensives have outperformed over the long run around the world because they carry the danger of underperforming a rising market, which means they expose fund managers to benchmark risk. Because of this risk, fund managers underweight defensives, causing them to be underpriced. It might instead be that they underperformed last year merely because of bad luck; all strategies - even the very best - do badly sometimes simply because there's so much noise in share prices.

Whatever caused low risk stocks to do poorly, one thing certainly wasn't the case. There was no rotation from low risk to high risk stocks in 2014. Quite the opposite. Our high-beta portfolio had a terrible year, falling by far more than its beta would justify.

One reason for this is simply that falling commodity prices hurt a lot of high-beta stocks badly.

But there might be more. The longer-term performance of high-beta shares is pretty mediocre; they have underperformed over the past five years, even though they should in theory have beaten a rising market.

There are two related things that might lie behind this. One is a fear of secular stagnation. Higher-beta stocks are often growth stocks. Pessimism about future growth prospects will therefore hurt a lot of them.

The other could be increased risk aversion. The fall in high-beta stocks might simply reflect an increased aversion to risk; it's part of the same process that has seen index-linked yields fall. This increased risk aversion is compatible with a rising market insofar as the latter is due to cheap and easy money.

And herein lies one reason why I'm interested in these no-thought portfolios. The performance of such portfolios doesn't simply tell us about investors' (changing) cognitive biases or attitudes to risk. Nor do they just show us how to beat the market. They also serve as a barometer of investors' attitudes towards economic prospects.