It’s been a catastrophic few months for momentum investing. In the final quarter of last year, my no-thought momentum portfolio (which comprises the 20 biggest risers in the 12 months to September) fell by more than 27 per cent, which means it underperformed the market in 2018 as a whole. That partly reverses huge outperformance in the previous few years.
So bad has its recent performance been that positive momentum stocks have now actually underperformed negative momentum ones in the past three years. The strategy of buying past winners while dumping past losers has stopped working.
This is not because one or two momentum stocks did badly. The losses were evenly spread across several stocks and sectors: Fevertree (FEVR), Hunting (HTG) and Softcat (SCT) to name but three all fell a lot in the fourth quarter. What’s not so clear is why momentum has done so badly.
One possibility, described by Victoria Dobrynskaya at Moscow’s National Research University, is that momentum has a high downside beta: it tends to do especially badly when the market falls. It also underperformed when the market fell early last year, for example.
If this is the case, then momentum should recover if or when the market bounces back. This is because if momentum is an especially risky strategy it should outperform in normal times to compensate investors for taking on these especial risks.
There is, however, a nastier possibility. It could be that investors wised up last year to the historic successes of momentum investing. In doing so, they piled into momentum stocks, thereby driving their prices up too far with the result that they have subsequently slumped.
Personally, I have mixed feelings about this explanation. On the one hand, it seems intuitive. Investors should not leave money on the table and so should wise up to underpricings thereby eliminating them. On the other hand, though, I’m puzzled as to why investors should have wised up only last year. We’ve known about the success of momentum investing for years: why was it only last year that investors cottoned on?
|Benchmark portfolio performance|
|in Q4||in 2018||last 3Y||last 5Y|
|Price performance only: excludes dividends and dealing costs|
Even if investors have wised up, however, it does not automatically follow that momentum has disappeared forever. It’s possible that the massive losses on momentum stocks will drive investors away from investing in them. If so, momentum stocks will become underpriced again and so will outperform.
I honestly don’t know what the explanation is here. All I can do is keep monitoring the performance of momentum so that time will tell us.
Momentum, however, is not the only strategy with a great track record that came a cropper in 2018. So too did defensive investing. My low-risk portfolio actually underperformed the market last year despite the fact that it was built to have a low beta, which means it should have beaten a falling market.
This is perhaps a failure of implementation rather than of defensive investing generally. My portfolio simply picked stocks with the lowest betas. This excluded many defensive stocks, which actually held up well during the market’s slump – especially larger ones such as Diageo, Unilever and the pharmaceutical giants.
If this is the case, then it challenges one of my more deeply held priors, as it suggests that a judgment-based approach to investing can sometimes succeed when a disciplined algorithmic one fails.
Although its absolute performance was poor, low-beta investing continued to beat high-beta investing last year. Of course, this is what should happen when the market falls. But it has also happened in the past five (and indeed 10) years. This is consistent with the “betting against beta” theory proposed by economists at AQR Capital Management. The idea here is that investors who are bullish but constrained from borrowing gear up their portfolio by buying high-beta shares. This means such stocks are generally overpriced and so underperform on average over the long run.
If, however, some shares are overpriced on average others must by definition be underpriced. These others will often be defensive ones, which are often neglected by bullish investors. This makes me suspect – albeit not strongly – that the underperformance of my defensive portfolio might be only temporary.
Another strategy did badly last year – value investing. Falls in stocks such as Intu (INTU), Galliford Try (GFRD), Stobart (STOB) and Kier (KIE) mean that high-dividend-paying stocks did badly on average. This is consistent with the fact that many value stocks are cyclical: high yields are sometimes compensation for taking on the risk of a big fall in a recession. Worries about the state of the economy thus hurt value stocks while good news about the economy benefit them. My value portfolio collapsed in 2008-09 but recovered strongly as the economy recovered in 2010-11, for example.
In truth, though, 2018 was a bad year for stockpickers in general. According to Trustnet, only 59 of 254 funds in the UK All Companies sector beat the Scottish Widows UK tracker fund last year. And even fewer beat FTSE 100 trackers. This happened because a few huge stocks such as AstraZeneca (AZN), Royal Dutch Shell (RDSB), BHP (BHP) and Diageo (DGE) did relatively well. Because market indices are weighted by capitalisation, such stocks have a high weighting in indices. In effect, this means that indices held up well relative to most stocks. Which means that tracker funds beat most stockpickers.
By the same token, it is when smaller stocks outperform that stockpickers do well. This would happen, I suspect, if we get good news about the UK economy this year – which is a big if.
The point of this exercise is not to recommend particular stocks or strategies. It is instead to help us understand how the market works, to highlight the conditions in which some strategies work and others don’t. I like to think this is a useful exercise. I hope you do too.
The new no-thought portfolios
Momentum (the biggest risers in the last 12 months): AG Barr, Auto Trader, Burford Capital, Craneware, Diversified Gas, Draper Esprit, Drax, EI Group, Evraz, Faroe Petroleum, Hikma, Hurricane Energy, Jardine Lloyd Thompson, John Laing, Ocado, Pearson, Plus500, PPHE Hotels, Qinetiq, SolGold.
Negative momentum (the biggest fallers in the last 12 months): ASOS, Bank of Georgia, BAT, Capita, First Derivatives, Indivior, Intu, IQE, Jupiter, Just Gp, Kier, Mediclinic, Metro Bank, Micro Focus, Old Mutual, Playtech, Std Life Aberdeen, Stobart, Ted Baker, Wm Hill.
Value (those with the highest dividend yield): Centamin, Centrica, Crest Nicholson, Dixons Carphone, Evraz, Galiford Try, Intu, Kier, Paypoint, Persimmon, Playtech, Plus500, Restaurant Gp, Royal Mail, Saga, SSE, Std Life Aberdeen, Stobart, Vodafone, Wm Hill.
High beta (the highest beta stocks over the last five years): ASOS, Aveva, Cairn Energy, Evraz, Faroe, etroleum, Ferrexpo, Fevertree, Fresnillo, Glencore, Hochschild, Hurricane Energy, Hutchison China, Indivior, Kaz Minerals, Mondi, Sirius Minerals, SolGold, Sophos, Stobart, Tullow.
Low beta (the lowest beta stocks): Amadeo Air Four Plus, BTG, Dart, Easyjet, GCP Student Living, GlobalData, Halfords, IG Group, IQE, James Fisher, Marshalls, OneSavings, Pets at Home, Phoenix , lobal, PP Betfair, Polypipe, Rank, Redde, Telecom Plus, Wizz Air.
Mega caps (the biggest stocks by market cap): Astrazeneca, BAT, BHP Billiton, BP, Compass, Diageo, Glaxo, Glencore, HSBC, Lloyds Bkg, National Grid, Prudential, RBS, Reckitt Benckiser, RelX, Rio Tinto, Royal Dutch, , Shire, Unilever, Vodafone.
All portfolios comprise 20 stocks, drawn from those with a market cap of over £500m