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Momentum stops working

Created:

2 October 2008

Written by:

Chris Dillow

Never mind the financial crisis. The third quarter was a terrible time for momentum investing. Although it didn't hold a single financial stock, our benchmark portfolio (the 20 biggest risers in the FTSE 350 in the second quarter) did terribly in the third.

It lost 22.2 per cent, compared to a loss of 13 per cent on the FTSE 350. This was largely because commodity stocks fell sharply.

This poor performance - which follows two years of good returns - suggests that the profits to momentum investing are a return for taking particular risks, rather than a pay-off from exploiting other investors' irrationality.

Benchmark portfolio performances in the third quarter

All returns exclude dividends

By contrast, the strategy most sensitive to the financial crisis has slightly out-performed the market. Our value portfolio - the 20 highest yielders as of three months ago, which included several housebuilders and banks - fell only 10 per cent, despite containing Bradford & Bingley. This happened because, until Lehmans went bust, housebuilders had been recovering - so much so that some (Barratt Developments, Bellway and Persimmon) are in our momentum portfolio for the current quarter.

Such bottom-fishing also helped smaller stocks out-perform. The 20 smallest stocks in the FTSE 350 fell just 1.6 per cent in the third quarter, partly reversing its earlier huge under-performance.

A further quirk of the third quarter was that high beta stocks (as measured by monthly returns in the previous five years) actually beat the index a little. This undermines the simplest version of the capital asset pricing model which says that market risk is the only systematic risk affecting share prices.

As you might expect, our low-risk portfolio has continued to beat the market, out-performing by 11.8 percentage points in third quarter.

In the last 12 months, it's lost only 12.5 per cent. That means it's beaten all but five unit trusts (of 295) in the UK all companies sector.

Of course, you'd expect it to fall less than the market. What's more remarkable, however, is its longer-term performance. In the last three years it has risen 12.3 per cent despite the FTSE 350 dropping 9.9 per cent. That's much better than the CAPM would predict. Only 10 funds in the all companies sector have done better.

Which means that 19 fund managers out of 20 can't do better than a simple no-brain portfolio based upon one of the oldest anomalies in the stock market.

And they get paid for that - by you.

There's more: Here's an Excel file showing the latest constituents of our no-brain portfolios.

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