Momentum investing has begun to pay off again. In the second quarter my no-thought momentum portfolio (which comprises the 20 biggest rising stocks in the 12 months to March) rose by 4.3 per cent.
In itself, this is only slight outperformance of the FTSE 350. But it is significant. Last year was a terrible one for momentum: my portfolio lost 22.4 per cent. But we did not know why. One possibility was that investors had wised up to the long-run historic outperformance of momentum investing and so piled into momentum stocks in 2017, causing them to become overpriced. This possibility led me to fear that the momentum effect might have permanently disappeared.
Its recent outperformance, however, has allayed this fear and strengthened my faith in another explanation. This is that momentum stocks have high downside betas. This is because when investors shift to 'risk-off' trades, they often close the positions they most recently took. This means they tend to sell stocks they’ve recently bought, which are those that have gone up a lot.
|Benchmark portfolio performance|
|in Q2||last 12M||last 3Y||last 5Y|
|Price performance only: excludes dividends and dealing costs|
If this is the case, it is very encouraging for momentum investors. This explanation implies that momentum should continue to outperform on average over the longer run, as a reward for taking on extra risk.
And remember that momentum’s long-run record is good. Despite last year’s drop, my momentum portfolio has risen over 60 per cent in the last five years. That would put it in the top 10 per cent of unit trusts in Trustnet’s all companies funds database.
Of course, slight outperformance over a few weeks isn’t sufficient to prove this. It’s just that my Bayesian updating process tweaks the dial away from the wising up theory towards the beta one.
Something else strengthens my faith in momentum investing. It’s that my negative momentum portfolio (the 20 biggest fallers in the 12 months to March) did badly in the second quarter, thanks to big falls in Kier (KIE), Indivior (INDV), Intu (INTU) and Metro Bank (MTRO). This fits the longer-term pattern for past losers to continue losing for a while.
This is consistent with the so-called disposition effect. A combination of wishful thinking and reluctance to admit that one was wrong causes investors to hold onto losing stocks. Because they don’t sell, such stocks stay overpriced for a while after bad news and so fall slowly. This is a warning to us all. Do not fall in love with your investments. The fact that you bought a stock is no reason for it to rise. Be prepared to sell losers. Yes. You’ll miss out on the occasional bounce, such as in ASOS (ASC) in the first quarter. But these are outnumbered by the likes of Keir, Metro Bank or Carillion, which continue falling.
Another strategy that’s had a bad three months is deep value investing. The 20 highest-yielding stocks in March fell by an average of over 12 per cent in the second quarter, thanks to big losses on Kier, Centrica (CNA), Plus500 (PLUAS) and Saga (SAGA). This is a warning that income stocks can be dangerous. A high yield can be a sign that a company is in trouble, and sometimes these troubles get worse. Harvard University’s John Campbell has shown that distress risk does not pay. Investors in Kier will corroborate this.
The last three months have also been bad for high-beta stocks, due to losses on AA (AA.), Fevertree Drinks (FEVR) and ASOS.
This is inconsistent with the capital asset pricing model, which says that high-beta stocks should outperform a rising market.
It is, however, consistent with an idea proposed by economists at AQR Capital Management. They point out that many fund managers cannot borrow as much as they’d like. This means that when they are bullish (as they are more often than not) they do not express that optimism by borrowing to buy shares generally, as the capital asset pricing model (CAPM) predicts they should. Instead, they leverage their portfolios by buying high-beta stocks – ones they expect to do especially well if the market rises. This, however, means that such stocks are on average overpriced and so subsequently underperform. The AQR economists show that high-beta assets generally tend to do badly. My data corroborates that. In the last 10 years my high-beta portfolio has risen only 16.3 per cent while the FTSE 350 has gained 85.5 per cent.
Our low-risk portfolio also underperformed in the second quarter, thanks to losses on Plus 500 and easyJet. In itself, this isn’t noteworthy. What is, though, is that this strategy has now underperformed in the last 12 months, having done well for years before then.
I suspect that this is evidence against one of my prior views – that simple algorithms beat judgment. The thing is that low-beta stocks can sometimes be risky. If a stock falls a lot when the market is doing well, it will have a negative beta. It will therefore seem to be low risk even if it is quite volatile and even it has fallen a lot recently and is the sort of stock we would therefore want to avoid given the poor performance of negative momentum stocks. For this reason, Plus 500 got into our 'low risk' portfolio.
By contrast, had we picked a low-risk portfolio based only upon judgment, we would – I suspect – have bought stocks such as Diageo (DGE) and Unilever (ULVR) and so done better.
This is not a conclusive argument against using simple algorithms. The fact that our low-risk portfolio has outperformed in the last 10 years counts for something, and the poor performance of some equity income funds reminds us that judgment doesn’t always add much to the stock selection process. But it is perhaps a warning that such algorithms might sometimes be improved by the human factor.
Our new no-thought portfolios
Momentum (the biggest risers in the last 12 months): 4imprint, Ab Dynamics, Aveva, BTG, Dunelm, Energean, Ferrexpo, Future, Games Workshop, Gamma Comms, Greggs, Halma, Kainos, Marshalls, Pets at Home, Polymetal, PureTech, RWS, Serco, Tarsus.
Negative momentum (the biggest fallers in the last 12 months): ASOS, Babcock, Centrica, Dixons Carphone, easyJet, Elementis, Hammerson, Intu, IP, Just, Mediclinic, Metro Bank, PlayTech, Plus500, Premier Oil, Royal Mail, Sirius, Tui, Victoria, William Hill.
Value (the highest dividend yielders): Amedeo Air Four Plus, British American Tobacco, BT, Centrica, Crest Nicholson, Diversified Gas & Oil, Evraz, Galliford Try, Hammerson, IG, Imperial Brands, International Consolidated Airlines, ITV, Persimmon, Plus500, Royal Mail, SSE, Standard Life Aberdeen, Tui, Wm Hill.
High beta (the highest beta stocks in the last five years): ASOS, Aveva, Cairn Energy, Essentra, Evraz, Ferrexpo, Fevertree, Fresnillo, Genel Energy, Glencore, Highland Gold, Hochschild, Hutchison China, IWG, Kaz Minerals, Melrose Industrials, Premier Oil, Sirius, SolGold, Tullow.
Low beta: Acacia Mining, Amedeo Air Four, Ascential, BTG, Dart, Equiniti, Flutter, GlobalData, Hill & Smith, IG, Kainos, McCarthy & Stone, OneSavings, Oxford Biomedica, Pets at Home, Phoenix Global, Plus 500, Tarsus, Telecom Plus, TP Icap.
Mega-caps: Anglo American, AstraZeneca, British American Tobacco, BHP Billiton, BP, Compass, Diageo, GlaxoSmithKline, Glencore, HSBC, Lloyds Banking, National Grid, Prudential, Royal Bank of Scotland, Reckitt Benckiser, RelX, Rio Tinto, Royal Dutch, Unilever, Vodafone.
All portfolios are formed from stocks excluding investment trusts with a market cap of over £500m.