2017 was another good year for momentum investing. My no-thought momentum portfolio (which comprises the 20 best-performing shares in the previous 12 months, rebalanced every quarter) gained 34.1 per cent in the year. It did better than all but one fund in Trustnet’s database of all companies unit trusts: Elite Webb Capital Smaller Companies Income and Growth (GB00B63JD951).
This has a devastating implication. It suggests that a lot of effort spent analysing stocks is wasted: you could have done better simply by buying stocks that had gone up a lot.
This is not a new development. In fact, momentum investing has done well for years. In the past five, it has returned over 150 per cent. Only two all companies funds (both run by Old Mutual) have done better.
|Benchmark portfolio performance|
|in Q4||last 12M||last 3Y||last 5Y||last 10Y|
|Price performance only: excludes dividends and dealing costs|
Nor is it a recent development confined to the UK. Back in 2001, Narasimhan Jegadeesh and Sheridan Titman pointed out that momentum stocks had beaten the US market since the 1960s. And since then researchers have found evidence for momentum effects in international markets, commodities and currencies. This year’s performance therefore merely adds to an abundance of evidence for momentum investing.
Instead, the oddity about 2017 was that negative momentum did well: past losers also beat the FTSE 350. Even including this outperformance, however, the longer-run performance of past losers has been poor.
Many of you, I know, are sceptical about momentum investing. Although the evidence is clear that it has worked in the past, it’s not obvious why this should be; the strategy doesn’t seem risky enough to warrant high risk premia. Such scepticism, however, might help explain why momentum has succeeded: knowledgeable investors have shied away from momentum stocks, which means their profits have not been bid away.
Last year was also a good year for another well-established anomaly. Defensive stocks also beat the market nicely. Again, this continued a long-run trend that has been found around the world.
However, high-beta stocks did even better in the year, thanks in large part to nice gains in some commodity stocks. Although this is what orthodox financial theory (the capital asset pricing model, CAPM) predicts, it breaks a long-term pattern. If we look at the past three, five, or 10 years high-beta stocks have actually underperformed the market. That’s consistent with a finding by researchers at AQR Capital Management that it pays to bet against beta – this is the case not just in equities, but in bonds and commodities too.
One strategy, however, had a poor year: value. Our no-thought value portfolio – which comprises simply the 20 highest yielding stocks – fell in price terms in the year. Losses on stocks such as Carillion (CLLN), Centrica (CNA) and Pearson (PSON), among others, dragged down performance. This isn’t a quirk of our portfolio. Several equity income funds also suffered this year.
I suspect that value stocks carry cyclical risk. They do well in good economic times, but badly in bad ones: their terrible performance during the financial crisis but recovery since 2010 is consistent with this. Their lacklustre performance this year perhaps reflects the fact that it has been a dull year too for the domestic economy.
The point of all this is not to recommend particular strategies. Instead, what I’m doing here is testing hypotheses. One hypothesis is the CAPM. It says that equity returns should be simply related to market risk, implying that high-beta stocks should outperform a rising market and low-beta ones under-perform, while value and momentum should do no better or worse than the market except insofar as their betas differ from unity. Alternative hypotheses are that momentum and defensives do well, and that value investing does well in good economic times and badly in bad ones. My no-thought portfolios are intended to test these theories in real time.
Our new benchmark portfolios
Here are my latest portfolios. All are drawn from the IC's equity screener, based on UK shares with a market cap of over £500m.
Momentum (the 20 biggest risers in the past 12 months): Ferrexpo, Fevertree, First Derivatives, Games Workshop, Hutchison China Med, IQE, Kaz Minerals, Morgan Sindall, NMC Health, Phoenix Global, PureCircle, Purplebricks, Randgold, Renishaw, Softcat, Sophos, SSP, Victoria, Wizz Air, XP Power.
Negative momentum (the 20 worst performers in the past 12 months): AA, Acacia Mining, AO World, Babcock, C&C, Centrica, Dignity, Dixons Carphone, Drax, Go Ahead, Hikma, Inmarsat, Petrofac, Pets at Home, Provident Financial, Saga, Serco, Sound Energy, Ultra Electronics, WPP.
Value (the 20 highest dividend yielders): Capita, Centamin, Centrica, Evraz, Galliford Try, Glaxo, Go Ahead, Highland Gold, Inmarsat, Kier, Marston's, Paypoint, Petrofac, Phoenix Group, Provident Financial, Redde, Royal Dutch Shell, Saga, SSE, Stagecoach.
Low risk (the 20 lowest beta stocks): AO World, Consort Med, Emis, Globaldata, Halfords, Homeserve, Indus, James Fisher, James Halstead, JD Sports, Nichols, Onesavings, Pets at Home, Phoenix Global, Polypipe, Rank, Redde, Saga, Smart Metering, Stock Spirits.
High beta (the 20 highest beta stocks): 3i, Ashmore, Asos, Centamin, Ferrexpo, Fresnillo, Glencore, Highland Gold, Hochschild, Just Gp, Kaz Minerals, Melrose Inds, Mondi, Old Mutual, Randgold, Raven Russia, Sirius, Smurfit Kappa, Sound Energy, Vedanta.
Mega cap (the 20 largest stocks): Astrazeneca, Barclays, BAT, BHP Billiton, BP, Diageo, Glaxo, Glencore, HSBC, Imperial Brands, Lloyds Banking, National Grid, Prudential, RBS, Reckitt Benckiser, Rio Tinto, Royal Dutch, Shire, Unilever, Vodafone.
All portfolios are drawn from the IC's equity screener, based on UK shares with a market cap of over £500m