Momentum's back

This is consistent with an idea in evolutionary finance - that stock markets are like population cycles.

When food is abundant, a species feeding on it multiplies. But this feeding depletes the food source, causing some of the species to die. That, in turn, allows the food source to grow again, giving a plentiful diet to the surviving members of the species, and so the cycle begins again.

Just as there is a cycle between a species and its food source, so there's a cycle between an investment strategy and its source of profits. The poor performance of momentum stocks last year caused some momentum investors to throw in the towel - the species declined. Their absence meant that momentum stocks were underpriced at the end of last year, with the result that profits have been big for the remaining momentum investors. The food source thus increased.

If this theory is right, momentum investing will not remain profitable, as investors will return to the strategy, which will bid up the prices of momentum stocks to levels from which subsequent returns will be poor. Unfortunately, though, we cannot predict when this will happen.

Momentum, however, has not been the only strategy that's done well so far this year. Our low-risk portfolio has also beaten the market. This is odd. It should in theory underperform a rising market and outperform only a falling one. But, in fact, it has beaten the rising market not just in the last three months, but also in the last one, three and five years.

This is consistent with the possibility that investors irrationally ignore dull defensive stocks, and prefer more glamorous ones.

This poses the question: isn't there the same danger with defensives that there is with momentum - that investors will eventually learn their error, and buy defensives, so raising their prices to a level from which subsequent returns will be poor?

Possibly. But it could be that the defensive anomaly is more hard-wired into markets than the momentum anomaly.

One clue that this is the case is simply its ubiquity. Defensive stocks have, on average, done better than they should over very long periods and in almost all markets. Another clue is that, in the last 12 months, it's not just low-risk stocks that have done well, but higher-beta ones too. How can it be that both low- and high-risk stocks outperform at the same time?

One possible reason is what economists call an agency problem. Professional fund managers are judged by their relative performance; a man who loses 10 per cent is a great performer if his rivals lose 11 per cent, and the man who makes 10 per cent is a numpty if his rivals make 11 per cent. For such managers, both low- and high-beta stocks are risky because they carry the risk of deviating from their benchmark. Low-risk stocks risk underperforming a rising market - the first quarter was unusual in this respect - while high-beta ones risk underperforming a falling market. Fund managers wanting to get close to a benchmark will therefore want to under-own both types of share. However, because they believe - rightly on average - that the market will usually rise, their bias against defensives is usually stronger than their bias against high-beta stocks. The upshot is that defensives are likely to be systematically underpriced, and so offer good subsequent returns.

Ocado appears in the new momentum portfolio

The momentum and low-risk anomalies give the impression that the stock market is - or at least has been - informationally inefficient. But the performance of some of our other portfolios suggests this is not always so.

Loser stocks have consistently underperformed in recent years. This suggests that - contrary to what we thought for many years - investors do not overreact to long runs of bad news, causing past poor performers to become underpriced. In this respect, perhaps they have wised up.

Our idiosyncratic risk portfolio has also underperformed. This is consistent with a key prediction of the much-maligned capital asset pricing model - that such risk should not be rewarded because investors can, by definition, diversify it away. Only systematic risk matters.

Perhaps the performance of value stocks corroborates this. These did appallingly in 2008-09 and, although they recovered a bit last year, they have underperformed a little this year. This is consistent with high dividend yields being (sometimes) a sign of cyclical risk. When such risk materialised in 2008-09 and the economy fell into deep recession, such stocks suffered horribly. And because the market's rally this year has not been based upon increased economic optimism (but rather a decline in tail risk), so they have underperformed this year too.

All this tells us that the question 'is the market efficient?' is too big a one. The answer is: yes, in some respects and no in others, and it varies from time to time. Economics is not like physics: there are very few robust law-like generalisations.

Many of you might object here, saying 'but I've beaten the market lately'. The performance of our small- and mega-cap portfolios might explain why. Mega caps have underperformed lately while small caps have outperformed. This tells us that most stocks have beaten the index. For example, in the last three years 65.5 per cent of shares in the FTSE 350 (excluding investment trusts) have beaten the index. This has been possible because the index is weighted by market capitalisation and so has been dragged down by a few large poor performers such as BP, RBS and Anglo American. BP, for example, has 30 times the weighting of, say, Invensys.

In this sense, many stock-pickers have been able to beat the market simply because most stocks have done so.

In this context, retail investors have an advantage over professional fund managers, because we don't have to worry about benchmark risk - the danger that we might lose our job if we underperform the market. The ability to ignore this risk means we can buy defensive stocks, which might be under-priced. It also means we don't have to worry about building a capitalisation-weighted portfolio and so hold large amounts of big stocks. This means that we are likely to outperform if mega caps continue to underperform.

We should not, however, overstate this advantage. Defensive stocks will underperform from time to time, if only because of ordinary noise in returns. And it's possible that mega caps will cease their recent underperformance. If they outperform, most stocks will underperform the market, causing many retail investors to underperform.

Nevertheless, this is at least a potential edge that retail investors have over fund managers. And it's one that has paid off recently.

OUR NEW PORTFOLIOS

Mega caps:(the 20 largest stocks): AstraZeneca, Barclays, BAT, BG, BHP Billiton, BP, Diageo, GlaxoSmithKline, HSBC, Lloyds Banking, Prudential, Reckitt Benckiser, Rio Tinto, Royal Dutch Shell, SAB Miller, Standard Chartered, Tesco, Unilever, Vodafone and Xstrata.

Small caps (the 20 smallest in the FTSE 350): Anite, Big Yellow, Bank of Georgia, Brewin Dolphin, Carpetright, Chemring, Cranswick, Dialight, Greggs, Heritage, KCom, Keller, Kentz, Kier, Menzies (J), Petropavlovsk, SDL, SuperGroup, Unite and Workspace.

Idiosyncratic risk (the most volatile in Q1, whose volatility cannot be attributed to moves in ther market): 888 Holdings, African Barrick, Bumi, Bwin, Centamin, ENRC, Ferrexpo, Home Retail, Imagination Tech, IPF, Kazakhmys, Kenmare, Lonmin, New World Resources, Ocado, Ophir Energy, Petropavlovsk, Regus, SuperGroup and Thomas Cook.

Losers (the biggest fallers in the last three years): African Barrick, Anglo American, Bwin, Cairn Energy, Centamin, Chemring, ENRC, Ferrexpo, FirstGroup, Halford, Heritage, Home Retail, Homeserve, Kazakhmys, Lonmin, Man, Petropavlovsk, RBS, Thomas Cook and Vedanta.

High beta (highest beta of monthly returns in the last five years): 888 Holdings, African Barrick, Centamin, De La Rue, Dixons, Enterprise Inns, Ferrexpo, Heritage, Hochschild, Kenmare, Ophir Energy, Pace, Playtech, RBS, St Modwen, SuperGroup, Taylor Wimpey, Telecom Plus, Thomas Cook and Unite.

Value (highest dividend yielders): Amlin, Aviva, Balfour Beatty, C&W Comms, Carillion, Evraz, First Group, Go Ahead, Halfords, Homeserve, Icap, Kier, Londonmetric, Man, Petropavlovsk, Phoenix, Resolution, RSA Insurance, SSE and Tullett Prebon.

Low risk (least volatile in the last five years, subject to no more than three from any one FTSE sector): ABF, AstraZeneca, BAT, Capita, Centrica, Diageo, Dignity, GlaxoSmithKline, Greggs, Londonmetric, Morrison (Wm), Pearson, Reckitt Benckiser, Reed Elsevier, RSA Insurance, Severn Trent, Tesco, Unilever, United Utilities and Vodafone.

Momentum (Q1's biggest risers): 3i, 888 Holdings, Ashtead, Bk of Georgia, Centamin, Computacenter, CSR, Dignity, Easyjet, Hikma Pharms, Howden Joinery, Intermediate Cap, Intl Cons Air, Mondi, NMC Health, Ocado, Playtech, Regus, SVG Capital and Thomas Cook.

Negative momentum (Q1's biggest fallers): African Barrick, Anite, Antofagasta, Aviva, Balfour Beatty, Debenhams, Evraz, Ferrexpo, Fresnillo, Hochschild, Homeserve, Kazakhmys, New World Resources, Petrofac, Petropavlovsk, Polymetal, RBS, Rio Tinto, SDL and Vedanta.