The past five years have seen several major underlying trends. At the start of 2004 we were still in the early stages of a bull market (or a prolonged bear market rally, depending on who you listen to) which became increasingly dependent on companies that were benefiting from cheap credit and appreciating asset prices. There was also markedly increased buyout activity based on income streams that private equity thought could be cleverly securitised. By mid-2007, this process came to an abrupt end courtesy of the credit crunch but, rather than an all enveloping bear market, a split developed with commodity stocks continuing to prosper on the back of the prevailing decoupling theory, while pretty much everything else plummeted. Commodity stocks joined the bear market with gusto in the third quarter of 2008. The market's most recent trough was in March, around the time our strategy's most recent quarter drew to a close.
This rollercoaster ride ultimately left the FTSE 100 down 12.3 per cent during the period we've monitored from the start of 2004 to the end of the first quarter of this year. Despite the turbulence of the time, momentum did a whole lot better. In fact, in spite of the incredible intensity of the bear market, our FTSE 100 winners' portfolio produced a 103 per cent cumulative return over the five-and-a-quarter year period excluding any transaction costs. The winners' portfolio only underperformed the index in four of the 21 calendar quarters we've looked at.
However, the winners portfolio was not immune to taking some gargantuan hits when things did go wrong. At the end of June 2008 it was sitting on cumulative gains since the start of 2004 of 213 per cent. Since then, it has fallen heavily. In one quarter alone – the third quarter of 2008 – the winners portfolio recorded an average loss across the 10 stocks of 32 per cent. That wasn't only a terrible absolute performance, it was a terrible relative performance outstripping the FTSE 100's drop by a massive 19 per cent. This fall cannot exactly be described as – in the parlance of our day – 'unprecedented'. Momentum does have a tendency to produce some shockers. The worst month recorded in the London Business School's extensive 1955-2007 study recorded a 33 per cent fall from its 20-stock winners portfolio in October 1982. That study unearthed some dire runs for the strategy, such as the 69 per cent decline recorded by the winners portfolio between December 1972 and December 1974.
Starting a momentum portfolio ahead of such a major drop would mean a lot of time would be required to make up lost ground. But, clearly, given the overall returns, momentum tends to win out in the end. Big market movements don't necessarily produce big upsets. The advent of the bear market, for example, hardly got in the way of the winners portfolio's impressive gains. From mid-2007, around the time the bear market began, to the end of the second quarter of 2008, the winners momentum portfolio delivered a cumulative gain of 16 per cent, prior to the cataclysmic third quarter of 2008. The FTSE 100 was down 15 per cent in the same period. From mid 2007 to the end of the first quarter of this year, the winners' portfolio recorded a decline of 25 per cent which was considerably better than the index's 41 per cent collapse.
Our testing of a losers' portfolio over five years produced less categorical results than the winners' portfolio. In fact, the losers, while underperforming the winners, still managed to significantly outperform the index itself over the period. They produced a 15 per cent positive return, and would therefore have produced a loss in that region if shorted.
While the losers' portfolio has fallen more heavily than the index during the recent bear market, it failed to impress before the mood turned sour in mid-2007. What's more, we found the losers' portfolio to have an unnerving ability to pick out some of the star performers of the following period as well as the dogs that continued to bark. It's always a danger that the turnaround story is just around the corner. This was particularly marked in the first quarter of 2009 which captured the first flurries of the recent rally into cyclicals. Not even falls of 50 per cent by Royal Bank of Scotland and 44 per cent by Lloyds Banking over the quarter could offset the stellar gains by other resources-orientated cyclicals in the portfolio, such as Lonmin, whose shares rose 56 per cent and Rio Tinto which put on 58 per cent. Overall, the losers' portfolio surged ahead by 15 per cent in the quarter which means it would have made for a painful shorting experience.
This disappointing outcome from the losers over the five-and-a-quarter years we looked at means a long/short portfolio would have been substantially outflanked by simply backing the winners and shorting the index, despite the mighty bear market. The cumulative gain from the long/short portfolio we looked at would have been 56 per cent. Running a fully-fledged momentum portfolio is a task that may prove too complex and costly for many private shareholders. Eclectica, a fund manager run by maverick fund manager Hugh Hendry, has recently launched a fund that aims to capture momentum returns for investors called the CF Eclectica UK Relative Momentum Fund, although its performance is yet to impress.
However, momentum theory does hold a number of more general lessons. For one thing, the saying that 'the trend is your friend' is an extremely apt one when markets are reasonably stable, but it can backfire badly at major inflection points. Indeed, momentum portfolios often work by latching onto strong investment themes relatively early in their life.
The success of the strategy in spotting winners means that a strong share price need not be taken as a sign that the best returns have already been had. At the same time, strong share price rises are something to be wary of if the prevailing mood starts to change – as demonstrated by the third quarter of 2008. The detail of our study lends credence to the saying, 'run the winners and cut the losers'.
