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Triumph of the defensives

Defensive and momentum investing have paid off handsomely in recent years. Will they continue to do so?
July 9, 2012

Ever since the financial crisis began in 2008, there has been heightened interest in the old question: are markets efficient or not? The performance of our no-thought portfolios suggests the answer is: no, in at least two ways.

First, defensive stocks have done better than standard efficient market theory predicts. Our low-risk portfolio (the 20 stocks in the FTSE 350 with the lowest volatility of monthly returns in the past five years, subject to no more than three from any one sector) rose 3.7 per cent in the past 12 months while the FTSE 350 fell 6.6 per cent.

Of course, you'd expect low-risk shares to outperform a falling market. What you wouldn't expect is for them to rise as the market falls, which is what happened in Q2; low-risk shares have a low beta, but a positive one, which implies they should fall less when the market falls, not rise.

Still less would you expect defensive shares to beat a rising market. But this is what's happened in the last three years. Since June 2009, our low-risk portfolio has beaten the FTSE 350 by 10 percentage points.

Performance of benchmark portfolios

Portfolioin Q2last 12 monthslast 3 yearslast 5 years
Momentum-9.4-17.626.117.5
Losers-13.6-36.1-24.7-76.5
Value-8.3-16.02.1-68.9
Idiosyncratic risk-18.4-15.327.2-30.3
High beta-18.3-22.36.6-38.9
Low risk1.13.743.24.1
Small caps-11.8-16.722.2-21.3
Mega caps-6.1-13.920.3-14.8
Negative momentum-10.2nanana
FTSE 350-3.7-6.633.1-14.6
Price performance only

All this is consistent with previous research, which has found that defensive stocks have done better than they should around the world and – in the US – over very long time periods. In this sense, defensives' outperformance (over the long-run and on average) is a pretty robust fact which argues against the standard interpretation of efficient market theory.

The second inefficiency – which also corroborates previous findings – is that, over the past five years, momentum shares (the previous quarter's 20 best performers) have beaten the market.

Now, in the last few months, this stellar performance has disappeared, and momentum has actually underperformed the market. However, I'm not sure whether this, in itself, is strong evidence that momentum effects have disappeared, for (at least) three reasons:

Returns are noisy. Over the past five years, the annualised volatility of momentum's relative returns has been 15.5 percentage points. This means there's a roughly one-in-seven chance of seeing the underperformance we've had in the past 12 months through bad luck, even if momentum on average outperforms the market by a whopping six percentage points per year on average.

■ Our momentum portfolio usually has a highish beta. This means a falling market should be expected to drag it down.

■ On another reading of the data, momentum has done well. Our positive momentum portfolio has beaten the negative momentum portfolio (the 20 worst performers in the previous quarter) over the last three and nine months.

However, these two anomalies – if such they are – do not mean the market is riddled with inefficiencies. In other respects, our portfolios suggest the equity market is more or less informationally efficient:

■ Our idiosyncratic risk portfolio has generally underperformed. This is consistent with the prediction of the capital asset pricing model, and its variants, that investors are not rewarded for taking on risk which can be diversified away.

Value stocks (the 20 highest yielders in the FTSE 350) have done badly. This suggests a high yield is a sign not that a share is underpriced, but rather that it carries extra risk, for which a high yield is compensation. And in recent years, this risk has materialised, causing value stocks to do badly. The likeliest such risk here is economic risk. Value stocks are often “cyclicals”, which tend to do badly when fears of recession increase – as they did in 2008-09 and in the past few months.

Loser stocks (the 20 worst performers in the last three years) have done badly. In part, this is for the same reason that value stocks have done badly. Losers expose investors to an extra risk, which has materialised in recent years – the risk being distress risk, the danger of companies going bust .

Herein, though, lies a warning. Loser stocks haven't always underperformed. Back in 1984, Werner de Bondt and Richard Thaler pointed out that past losers tended to bounce back – that is, investors overreacted to bad stocks, causing them to eventually become underpriced and so to offer good returns.

So why hasn't this happened recently?

It's because investors (sometimes) learn from their mistakes. As they realised that stocks had overreacted in the past, some investors bought them in the hope of profiting from a recovery in their prices. But as more and more investors did this, they supported their prices and so removed the overreaction that was the source of profits.

In other words, we shouldn't think of stock markets as efficient or inefficient, but rather as adaptive. As investors become aware of a mispricing, they tend to bid it away, causing the market to be efficient. This didn't just happen with loser stocks. It also happened to small caps in the mid-80s; investors learnt that these had made great returns in the past three decades, and so piled into them, with the result that prices rose so high that returns for much of the 1990s were poor.

Herein lies a nasty paradox. In most walks of life, a large body of evidence gives us a reason to believe strongly in something and to act accordingly. In finance, however, this is not necessarily the case. The stronger the evidence that a strategy works, the more likely it is that everybody knows about it and so have begun to bid away their profits. Paradoxically, therefore, the powerful evidence for the success of momentum and defensive investing gives us a reason not to invest accordingly.

So, should we be wary of defensive or momentum investing? It is – of course! – tricky to say.

For defensives, one reason for their outperformance could be an eliminable cognitive error – a tendency to overlook dull shares in preference for something more glamorous. But it's also possible that their outperformance arises from the fact that, sometimes, investors actually prefer riskier stocks, and so leave defensives underpriced. This preference has (at least) three sources:

1. Sometimes, such as in the spring or during bubbles, investors just want to chase risk.

2. Sometimes, they are desperate to recoup past losses, and so buy or hold risky stocks in the belief that these offer a better chance of rising sufficiently to make up for past losses.

3. Professional investors who expect the market to rise (the majority opinion most of the time) would avoid defensives for fear that these would underperform a rising market and so cause them to underperform their peers.

And here's the problem. It's unlikely that motive 1 or 2 is especially strong now – which argues for defensives underperforming. But motive 3 is likely to be as strong as usual.

In the case of momentum, the likeliest cause of outperformance in the past is a simple cognitive error – the tendency to underreact in the short term. This is the sort of mistake which is eliminable by learning. There is, therefore, a danger that investors wise up to their error and so eliminate the source of momentum profits.

But here's the problem. The adaptivity of markets works both ways. Yes, profit opportunities disappear as investors wise up to them. But they also appear as investors shy away from them. It could be that the underperformance of momentum investing in the last few months has deterred some people from becoming momentum investors. If so, then momentum investing might start working again.

These considerations tell us nothing more than the fact that we just can't tell in advance which sort of investment strategy will work. What we do know, though – and what our no-thought portfolios tell us – is that some work sometimes. Which is evidence against the most dogmatic and simple-minded versions of the efficient market hypothesis.