Efficient, for now

■ High-beta stocks rose by 12.8 per cent in the fourth quarter (Q4), outperforming all our other portfolios. This is consistent with the theory that taking market risk pays well in good times.

■ Small caps, value stocks and negative momentum all beat the market in Q4. This is what you'd expect, given that such stocks are riskier than average: value stocks and small caps carry cyclical risk, and negative momentum stocks expose us to distress risk.

■ Low-risk stocks underperformed the market, which is what you'd expect to happen if investors' appetite for risk rises.

■ Momentum stocks did no better in Q4 than you'd expect given their beta. This suggests that one of the best anomalies of recent years has disappeared.

The only significant blot on this picture of an efficient market is the performance of stocks with idiosyncratic risk - that is, the 20 most volatile stocks in Q3, whose volatility was unrelated to moves in the market. Theory says these should have only average returns, because their risk is - by definition - diversifiable, and investors should not be rewarded for taking on diversifiable risk. However, in Q4 they were rewarded quite handsomely.

This general efficiency is notable because it is so rare. If we look at longer-term performance, we can see some big deviations from efficiency. For one thing, higher-beta stocks have underperformed in the last three years despite the fact that, with the market rising, they should have outperformed. And for another, both low-risk and momentum stocks did better in the last three years than their riskiness would imply.

You can be forgiven for being confused here. For years, the big question in finance has been: are markets efficient or not? If they are, then the time and money spent on picking undervalued stocks is wasted. And if they are not, it isn't. But which is it? The evidence of the last three months points to markets being efficient, but the evidence of the last three years points to them being inefficient.

However, newer thinking about financial markets - inspired largely by Andrew Lo at the Massachusetts Institute of Technology - suggests that this old question is the wrong one. Markets are not so much efficient or inefficient as adaptive, or evolutionary.

Think of investment strategies chasing profits as being like species hunting a food source. If a food source (profits) becomes abundant, the species feeding off it will multiply. But this will eventually deplete the food source, causing the species to shrink in size. But if the species shrinks sufficiently relative to the food source, it will then be able to thrive again.

In this way, just as there are population cycles in biology, so investment strategies will wax and wane. A good example of this was the fate of small-cap stocks in the 80s and 90s. In the 80s, economists discovered that small caps had for a long time offered good risk-adjusted returns; there was a plentiful food source. This led to rapid growth in the species of small-cap investment strategies; not only did ordinary investors turn their attention to such stocks, but unit trust and investment trusts were set up to invest in smaller stocks. However, this buying bid up the prices of small stocks to such high levels that they fell in the 1990s; the food source became depleted. This caused investors to lose interest in the sector; the species died back. But by the late 90s, small caps were so out of favour that they subsequently did very well.

We've seen similar population cycles in some of our benchmark portfolios.

For example, momentum did very well between 2007 and 2011, but underperformed in 2012. This suggests that the growth of momentum investment strategies in response to their past success bid up the prices of momentum stocks, thus eliminating their great profits. Any investment strategy, if sufficiently popular, becomes self-defeating as it moves prices against itself.

However, the point about cycles is that what goes around comes around. This is what happened to defensive investing. Until the mid-2000s, this did very well. However, the very popularity of defensive investing meant it caused returns to be only lacklustre in much of 2008 and 2009. Once they fell out of favour, though, defensive stocks were sufficiently cheap in late 2009 to have offered nice returns since. However, defensives' mediocre performance in Q4 suggests that the strategy might again have become too popular.

A similar upturn has been seen in value stocks. These did atrociously not only during the 2008-09 recession but also during the following upturn. This caused such stocks to fall out of favour. But with prices very low at the end of 2011, they delivered great returns in 2012 for the few value investors that remained.

Thinking about markets in this evolutionary perspective suggests that we should not expect the apparent efficiency of the last few months to persist. There's no strong reason to suppose that an efficient market is a stable equilibrium, any more than a momentum-driven market is such an equilibrium; this is the message of a classic paper written in the late 70s by Sanford Grossman and Joe Stiglitz.

So, which strategies will deliver above-normal returns in 2013? Here, sadly, the analogy between investing and evolutionary biology breaks down. Although population cycles can have a regular and predictable periodicity, this is not so true of cycles in investment strategies. Our understanding of financial markets has progressed in recent years - but not to the point which permits accurate forecasting of which strategies will work and when. And perhaps this point will never be reached.