When good strategies turn bad

My no-thought momentum portfolio (which comprises the 20 best-performing shares in the previous 12 months) has lost 13.6 per cent in the past 12 months, significantly underperforming the FTSE 350. This follows years of outperformance.

Such underperformance could be a sign that investors have finally wised up to the benefits of momentum investing. Maybe early last year they piled into momentum stocks, causing them to become overpriced, with the result that they have subsequently done badly.

This, however, is not the only possible story. Victoria Dobrynskaya at Moscow’s National Research University suggests another. She shows that momentum stocks have unusual betas. They tend to underperform both falling markets and recovering ones – a V-shaped market, of the sort we've seen since last spring, is terrible for momentum. To compensate for these risks, they must offer good returns in more normal times. Their performance in the past 12 months fits this pattern: my momentum portfolio did especially badly late last year and has recovered less than the market so far this year.

A third possibility has been proposed by the Massachusetts Institute of Technology's (MIT) Andrew Lo. He believes that investment strategies are like population cycles in biology. When there are many members of a species chasing a scarce food source, some die out. That allows the food source to grow back. But this allows the depleted population to multiply in numbers again – until it runs down the food source again thus restarting the cycle. In the same way, evidence that a strategy works in the stock market causes an increase in the numbers following that strategy. But their buying causes prices to rise, thus reducing returns – in effect bidding away the anomaly. In response to this, some investors give up the strategy, which causes the anomaly to reappear thereby allowing the few who have stuck by the strategy to make nice profits again.

Our first explanation suggests we should give up momentum investing for good. Our second two, however, suggests we shouldn’t, as it will return to profit eventually. In truth, it’s impossible to say which is right.

This, of course, is not just a problem for momentum investing. It’s a problem for all successful stockpicking methods. If a fund manager with a good track record starts underperforming this might be because other investors have cottoned on to the secret of his success and so have piled into the stock he likes, thereby causing them to become overpriced and therefore permanently removing his edge. Or it might be that we have merely suffered the down phase of the population cycle and that the manager will make money again if only he or she has the discipline to stick to his strategy.

In fact, this is also a problem for another of our strategies – defensive stocks. These too have had a poor 12 months after years of outperformance. I’m less troubled by this, however, than I am by the underperformance of momentum. It might be due not to a general disappearance of the defensive anomaly, but rather to bad implementation. My defensive portfolio is based simply on picking stocks with the lowest betas over the past five years. Had we focused on larger defensives with big economic moats, such as Diageo or Unilever, our portfolio would have held up much better at the end of last year.

What’s more, we have a good risk-based reason to expect defensives to do well over time. It’s that those fund managers who are judged on relative performance are reluctant to hold them for fear of underperforming a rising market. This causes defensives to be underpriced, thus offering decent returns to those who can afford to ignore that benchmark risk.

The counterpart to defensive stocks doing badly is that high-beta ones have done well in the past three months – my high-beta portfolio rose 14.7 per cent in the first quarter.

You might think this is natural; high-beta stocks should beat a rising market, shouldn’t they? In fact, it’s less common than you might think. In the past 10 years – roughly since the trough of the market during the 2008-09 recession – my high-beta portfolio has actually hugely underperformed the 82.9 per cent rise in the FTSE 350.

Economists at AQR Capital Management have explained this. They say that many investors face borrowing constraints, so that when they are bullish they cannot borrow to buy the market, as conventional economic theory says they should. Instead, they express their bullishness by buying high-beta stocks. This means these are overpriced, and so underperform subsequently on average.

Why, then, have they done well so far this year? I suspect it’s a sectoral story. Much of this performance has been driven by resources stocks such as Ferrexpo, Evraz and Kaz Minerals doing well – perhaps in part because investors have rejoiced in tentative signs of a pick-up in the Chinese economy. It’s possible that this pick-up might continue: we have seen a recovery in growth in the M1 money stock, which is a nice lead indicator of output generally. History, however, warns us against chasing high-beta stocks because of this: good news for these tends to be swiftly discounted.

With global cyclicals having had a good first quarter you might expect value stocks to have done well, because high yields are often a sign of cyclical risk. In fact, though, my value portfolio fell slightly in price terms thanks to poor performance by (among others) Kier (KIE), Intu Properties (INTU), Plus 500 (PLUS) and Royal Mail (RMG). This reminds us that it is risky to buy stocks that are in distress – their troubles can get worse.

It also reflects something else. The first quarter was a good time for big stocks. My equal-weighted basket of the 20 largest rose 9 per cent, while the FTSE Small Cap index rose only 4.7 per cent. This could be because worries about Brexit contributed to investors preferring global companies to ones that are more sensitive to the UK economy.

This in turn has an implication for all stockpickers. If a handful of big shares are beating the market, brute maths means that most stocks are underperforming it. Which in turn means that most stockpickers underperform. In the first quarter, most unit trusts in Trustnet’s database of all companies funds underperformed Vanguard’s All-Share tracker fund – and some FTSE 100 trackers did better than this. One underappreciated aspect of Brexit, therefore, might be that it is proving good for tracker funds and bad for stockpickers.

The new benchmark portfolios:

Momentum (the biggest risers in the past 12 months): 4imprint, Auto Trader, Aveva, Diversified Gas & Oil, Dunelm, EI, Energean Oil & Gas, Entertainment One, Future, Greencore, Greggs, Gulf Keystone, Inmarsat, Jardine Lloyd Thompson, JD Sports, Kainos, Micro Focus, Ocado, PPHE Hotels, SolGold.

Negative momentum (the biggest fallers in the last 12 months): 888 Holdings, ASOS, Bank of Georgia, Centamin, Elementis, GVC, Indivior, Intu, IQE, Just, Kier, Mediclinic, Metro Bank, Old Mutual, Playtech, Royal Mail, Spire, Tui, Victoria, Wm Hill.

Value: Amadeo Air Four, Centrica, Crest Nicholson, Evraz, Galliford Try, Hammerson, IG Group, Intu, Kier, Pay Point, Persimmon, Plus500, Royal Mail, Saga, SSE, Standard Life Aberdeen, Stobart, Tui, Vodafone, Wm Hill.

 High beta: 3i, AA, ASOS, Aveva, Cairn Energy, Essentra, Evraz, Ferrexpo, Fevertree Drinks, Fresnillo, Genel ,Energy, Glencore, Hastings, Hochschild, Hutchison China, Kaz Minerals, Premier Oil, Sirius Minerals, Sol Gold, Tullow.

Low beta: Acacia Mining, Amadeo Air four, BTG, Chesnara, Dart, Easyjet, Equiniti, GCP Student Living, Hill & Smith, IG, McCarthy & Stone, One Savings, Pets At Home, Phoenix Global, Plus500, Paddy Power Betfair, Rank, Telecom Plus, TP ICAP, Wizz Air.

Megacaps: 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 are drawn from UK stocks excluding investment trusts with a market cap of over £500m.