- Defensive stocks have had a bad start to the year, but they do well on average over the long run.
- Some risks (such as those in value and high-beta stocks) do not pay off even in the long run.
So far, 2022 has been a bad year for almost all stock-pickers. Only 21 of 244 funds in Trustnet’s all companies unit trust sector have beaten Scottish Widows All-Share tracker – and most of those have been FTSE 100 trackers.
There’s a simple reason for this. Stock market indices, and hence tracker funds’ portfolios, are weighted by market capitalisation so Shell, with a market cap of £160bn, has almost 35 times the weighting of the biggest FTSE 250 stock (Unite). Which means that if a few big stocks outperform small ones, the All-Share index will outperform most stocks, with the result that most stock-pickers will underperform.
And this is just what’s happened. So far this year, Shell has risen 24.2 per cent while the FTSE 250 has fallen 10.9 per cent. Other big commodity stocks have also done well. In fact, the big five of them (Shell, BP, Anglo American, Rio Tinto and Glencore) have risen by an average of 25 per cent so far this year, adding 3.6 percentage points to the All-Share index. Without their performance, the index would be 5.1 per cent down so far this year rather than 1.5 per cent down.
Whether you’ve beaten the market this year is therefore to a large extent simply a question of your position in big commodity stocks. If you were overweight in them at the start of the year, you’ve probably beaten the market. And if you were underweight, you’ve probably underperformed. And most active fund managers were underweight.
In this context, it should be no surprise that my no-thought model portfolios have underperformed so far this year.
What is a surprise, though – especially in light of the general market’s fall – is the poor performance of my low-risk portfolio. It fell by 15.6 per cent in the first quarter. Its alpha (that part of returns that cannot be explained by its covariance with the market) has been worse recently than at any time since I started the portfolio in 2005.
|No-thought portfolio performance|
|in Q1||last 12M||last 3Y||last 5Y||last 10Y|
|Price performance only: excludes dividends and dealing costs|
To a large extent, this is because of collapses in the prices of Russian-exposed stocks such as Eurasia Mining, Polymetal and Petropavlovsk (although Just Eat and Pets at Home also did badly). Of course, such stocks were risky: doing business in Russia always has been. But those risks were largely independent of general UK market risk, so such stocks had low betas and so entered my portfolio.
Which tells us that it is difficult to identify low-risk stocks. Stocks that have had low betas in the past might well not keep those low betas. In this sense, 'defensive' stocks are a misnomer: they are risky.
But, on average, we are well paid for taking these risks. In the last 10 years, my low-beta portfolio has beaten the market. This is not an idiosyncratic quirk of my particular portfolio. Economists at Robeco Quantitative Investments have shown that, over the long run, less volatile stocks do better than they should in all major stock markets. On average, then, it pays to be defensive.
The converse of my defensive portfolio is my high-beta portfolio. This held up well in the first quarter, thanks to big rises in Harbour Energy and Kosmos Energy. Such relatively good performance is not typical, though. Over the last 10 years, my high-beta portfolio has greatly underperformed the market. Again, this is no quirk. It corroborates work by economists at AQR Capital Management showing that it pays to bet against beta.
One strategy has done even worse than defensives so far this year – negative momentum. My portfolio of last year’s 20 biggest losers fell by 20 per cent in the first quarter. We cannot attribute this merely to a Russia effect: THG, Just Eat, Asos and Aston Martin Lagonda all had bad quarters.
Here, however, there is a huge difference with my defensive portfolio. Whereas the latter has done well over the long term, negative momentum has not, except for a big jump in late 2020 when the discovery of a Covid vaccine boosted past losers such as Carnival and Cineworld. It has underperformed the market by almost 80 percentage points in the last 10 years. In risk-return terms, this makes little sense. Stocks that have fallen a long way are riskier than average: they are making losses or their business model is being called into question. And, in theory, higher risk should mean better average returns. That this hasn’t happened suggests something else is going on. This something is probably underreaction. Investors don’t respond sufficiently to stocks receiving bad news, but rather cleave too strongly to their prior belief that they are good stocks, and hold onto them in the hope of breaking even. Such underreaction means past losers are on averaged overpriced and so deliver poor returns.
The flipside of past losers doing badly is that past winners should do well. In the first quarter, however, this was not the case. My momentum portfolio lost 6.7 per cent as falls in Future. Greggs and Impax among others outweighed big rises in Serica Energy and Pantheon Resources.
Over the long run, however, my momentum portfolio has done astonishingly well. Which again is no mere quirk. Research shows that momentum investing works in the US, in international markets, in commodities and in foreign exchange markets. My portfolio is just one more data point of evidence. But it is a significant one. In the last 10 years, it has beaten all but eight funds in Trustnet’s all companies sector. A simple policy of buying stocks that have gone up has beaten almost all other strategies. This suggests that thinking does not add much value to the investment process.
In part, momentum’s great performance is a reward for taking risk: momentum stocks do sometimes underperform falling markets, as we saw during the start of the pandemic. But this is unlikely to be the whole story. Momentum also does well simply because investors underreact to good news.
Yet another strategy to have had a bad quarter was value investing. My portfolio of the 20 highest yielders fell, thanks to slumps in Evraz, Ferrexpo and Polymetal offsetting rises in Rio Tinto, BHP and BAT.
This continues a long trend for value stocks to do badly despite being riskier than others: a high yield is often a sign of extra risk, often in the form of exposure to recession. This might be because a world of slow growth – which we’ve had in the last decade – is one in which the upside to taking cyclical risk rarely materialises. Whatever the reason, we have yet another risk that does not pay.
Which brings us to the general point. Textbook economics and common sense tell us that greater risk should mean greater reward over the longer term: you’ve got to speculate to accumulate. But this is not true. Many risks such as those in past losers, value stocks and high-beta stocks do not pay off on average. But other risks such as those in momentum or defensive stocks do.
We can explain this. Investors underreact to good and bad news, underrate the virtues of dull stocks, and chase the small chance of big gains. But this merely leads us into a puzzle. In principle, investors should have wised up by now to these mistakes and so eliminated them. Perhaps the recent poor performance of defensives and momentum is a sign that they have done so. But whenever I have suspected this in the past, I have been proved wrong. Will I be again? We can only find out by monitoring such strategies.
The new no-thought portfolios.
Momentum (the best performers in the last 12 months): Alpha FX, Brewin Dolphin, Clipper Logistics, Drax, EnQuest, Glencore, Indivior, Investec, John Menzies, Kosmos Energy, Meggitt, MP Evans, Next Fifteen, Safestore, Serica Energy, Shell, SolGold, South32, Ultra Electronics, Watches of Switzerland.
Negative momentum (the worst performers in the last 12 months): 888, Asos, Aston Martin, Boohoo, CMC Markets, Countryside Partnerships, Deliveroo, Dr Martens, Ferrexpo, Flutter, Frontier Developments, JD Wetherspoon, Just Eat, Moonpig, Ocado, Polymetal, PureTech, S4 Capital, THG, Trainline.
Value (the highest dividend yielders): Abrdn, Ashmore , Atalaya Mining, BHP, Centamin, CMC Markets, Direct Line, Diversified Energy, Ferrexpo, Genel Energy, Gulf Keystone, Imperial Brands, Jupiter, M&G, Persimmon, Phoenix, Polymetal, Rio Tinto, Seplat, Synthomer.
High beta: Asos, Carnival, Crest Nicholson, easyJet, Elementis, EnQuest, FirstGroup, Gulf Keystone, Hammerson, Harbour Energy, International Consolidated Airlines, IWG, Jet2, John Menzies, Kosmos Energy, Micro Focus, SIG, Stagecoach, Tullow, Vistry.
Low beta: Assura, CMC Markets, Diversified Energy, Fresnillo, Hikma, Hipgnosis, Indivior, JTC, Kainos, National Grid, Pennon, Pets at Home, Plus 500, Polymetal, Primary Health, PZ Cussons, Reckitt Benckiser, Smart Metering Systems, Unilever, YouGov.
Mega caps: Anglo American, AstraZeneca, BAT, BHP, BP, Compass, Diageo, Experian, GlaxoSmithKline, Glencore, HSBC, Lloyds Banking, London Stock Exchange, National Grid, Prudential, Reckitt Benckiser, RelX, Rio Tinto, Shell, Unilever.
All portfolios are equal-weighted baskets of 20 stocks other than investment trusts with a market cap of over £500m.