Have investors finally wised up? This is the question posed by the poor performance of my no-thought defensive portfolio in the past three months.
It fell by 8.1 per cent in the third quarter, far more than the FTSE 350 dropped. This wasn’t because of any one share: Thomas Cook, IQE, IG, Hill & Smith and Indus Gas all did badly.
This partly reverses years of good returns – although even after its recent fall, the portfolio has easily outperformed the FTSE 350 in the last 10 years. And it’s inconsistent with decades of evidence from around the world, which tells us that defensives tend to beat the market on average – a finding that is robust to different measures of defensiveness. (My portfolio is based upon betas in the last five years, but researchers have found that a similar thing is true if we use shares’ volatility instead.)
Of course, this could be just bad luck; even the very best portfolios do badly sometimes simply because there is lots of noise in share prices.
|Benchmark portfolio performance|
|in Q3||last 12M||last 3Y||last 5Y||last 10Y|
|Price performance only: excludes dividends and dealing costs|
But it might be due to something else. Maybe investors finally woke up in the spring to the abundant evidence that defensives do well. In doing so, they would have bought them, thus driving their prices up to unsustainably high levels. There’s a precedent for this. In the mid-80s investors cottoned onto the fact that small caps had outperformed for decades. That caused them to buy such stocks, thereby driving their prices up so high that they went on to underperform bigger stocks for a whole decade.
Right now, we cannot tell which of these it is. Two things, however, make me tentatively favour the luck theory.
One is that the good performance of defensives wasn’t wholly due to investors making errors of judgement. It also happened because defensives are in one sense badly named. They carry a particular danger – benchmark risk. If the market rises a lot, defensives would probably underperform. This makes them unattractive to those fund managers who are judged by their returns relative to others. Such managers avoid defensives, causing them to be underpriced and to offer good returns to those of us who needn’t worry about benchmark risk. There’s no reason to suppose that this reason for defensives to do well has disappeared.
Secondly, the obverse of defensives’ traditional outperformance is still with us – namely, the bad performance of high-beta stocks. My high-beta portfolio fell in the third quarter, thus continuing its long underperformance. This fits the 'betting against beta' hypothesis proposed by economists at AQR Capital Management. The idea here is that some fund managers cannot borrow as much as they’d like. When they feel bullish therefore – and they usually do – they express this not by borrowing to buy shares generally but by buying high-beta shares. In effect, they leverage their portfolio by increasing beta rather than increasing borrowing. This causes high-beta shares to be overpriced and so to underperform on average.
This process is still at work, which poses the question: why, then, shouldn’t its obverse – the good performance of low-beta stocks – also be in place?
That said, I suspect there is a problem with defensives: they are harder to find. It used to be that we could look to utilities and to companies with strong brands such as Unilever and Diageo for defensiveness. But we can no longer do so with confidence. Utilities carry political risk – the danger that a Labour government will nationalise them on unfavourable terms or regulate them more toughly. And big brand stocks carry another form of wising-up risk – the danger that investors have wised up to the historic value of what Warren Buffett calls “economic moats” and so have driven their prices up too far. These problems mean it is now harder to implement defensive investing, even if the principle behind it remains sound.
There’s one area, however, where investors have not wised up yet: momentum. My momentum portfolio (the 20 stocks with a market capitalisation of over £500m which rose most in the previous 12 months) beat the FTSE 350 yet again in the third quarter. This continues years of great returns. In the last five years, it has doubled in price. That means it has beaten all but five of the 225 funds in Trustnet’s all companies database. And this, remember, is a no-thought portfolio – one that devotes no effort to stock selection at all other than the simplest of screens. This suggests that many traditional tools of stock-pickers actually subtract value for the investor.
This, of course, is no recent idiosyncrasy. Research tells us that momentum has worked for decades in US stocks as well as in commodities and currencies. Its good performance in the UK recently is merely a specific manifestation of a general fact.
This puzzles me. We have some theories that suggest that momentum stocks are riskier than others and so should carry a risk premium. For example, they might have the wrong sort of beta or they carry the danger that they will get into trouble by growing too fast. For me, though, (and this is a subjective view) the risk premium momentum stocks have enjoyed in the last 10 years just seems too big to be explained by these risks.
This throws us back onto behavioural explanations, the most plausible of which is that investors simply underreact to good news about shares with the result that such news is not immediately and fully embedded into prices. This, however, runs into its own problem: why have investors not wised up to this? This is a genuine puzzle.
What’s not so puzzling is the performance of negative momentum stocks – the biggest fallers in the previous 12 months. These have usually underperformed the FTSE 350 (except for a brief period in 2015-16), which suggests that investors underreact to bad news as well as good, causing stocks that experience bad news to be overpriced. This warns us to be very wary of buying dog stocks in the hope of a bounce back.
What’s also quite normal is the performance of high-yielding stocks. These tend to do very badly in recessions but better in economic upturns. They carry cyclical risk. But recently, they’ve also carried regulatory risk; SSE and Vodafone underperformed in the third quarter in part perhaps because of fears of what a future Labour government might do to them.
Finally, I should remind you of the point of all this. It is not to recommend stocks or to show how clever we are at finding ways to beat the market. The strategies I monitor here are very simple implementations of ones that researchers have found to deviate significantly from market returns – positively in the case of momentum and defensives and negatively in the case of negative momentum and high beta. The point is to test out-of-sample whether these performances continue – a possibility which has implications both for efficient market theory and for the sort of things you should at least consider when picking stocks.