The No-Thought portfolio strikes back

Although the index’s 10 largest constituents posted a total return of 0.9 per cent in the period – thanks to the resilience of the sterling-priced shares of dollar-earning resources companies – horrible sentiment across the rest of the market led to a decline of 4.4 per cent in simple price returns, or 3.4 per cent once dividends are factored in.

Given this torrid backdrop, our No-Thought portfolio did pretty well in the three months to 30 September. The screen, which takes its quarterly selections from the blue-chip index, was up 2.4 per cent in simple share price terms, or 3.3 per cent including dividends. On either measure, outperformance was around 6.7 per cent.

That puts the portfolio ahead of the FTSE 350 over almost any period since the fourth quarter of 2017, assuming an equally weighted total stock rebalancing every three months. The one notable exception during this helter-skelter of a half-decade is the two-year return, during which time the index is up 14.2 per cent in simple price terms, compared with the screen’s 0.3 per cent negative return.

These stark differences – happy days in a bear market, and pain at the start of a vaccine-fuelled bull rally – tell you a fair bit about the screen. To be specific, what worked wonders for the No-Thought portfolio over the past three months (and terribly in the final quarter of 2020) is its relatively high allocation to shorts. Of its six sets of investing strategies, two – negative momentum and high-beta – work by betting on share price falls.

Over the past fortnight, the news has been full of stories of hedge funds betting on falls in the pound’s value against the dollar. Anyone who doesn’t make a habit of looking at swings in currency markets could be forgiven for thinking that an evil cabal within the City has recently conspired with the government to crash sterling – rather than followed a trend that, depending on how you frame it, has been running since either the spring of 2021, the summer of 2014, Lehman Brothers’ collapse or the end of the Bretton Woods system in 1971.

In truth, these accounts simply highlight just how powerful (and tempting) a force momentum can be to investors. Similarly, anyone who continually bet against the worst-performing or most volatile UK stocks over the past year is likely to have done well. By refreshing their selections once a quarter, our negative momentum and high-beta picks have returned 79 and 54 per cent, respectively, since this time last year.

That performance, together with a modest assist from the index’s resilient resource-heavy megacaps, has completely offset dire returns from positive momentum, value and low-volatility strategies. Factor in dividends (which I have only been tracking since April), and the portfolio’s returns improve from 7.4 to 9.1 per cent, a 14 per cent outperformance over the past (pretty dismal) year.

As the aim of the screen is to beat the FTSE 350, this is clearly a positive.

However, readers may recall that a lot of time was dedicated to discussing the screen’s potential issues at its re-launch three months ago. Despite its strong recent run, we need to be live to how the strategy might falter should market conditions shift. Fortunately, a clearer picture is emerging of what works, what needs to change, and what looks like less of a problem than first appeared.

One concerns the portfolio’s size. While the screens in these pages are not designed to be off-the-shelf portfolios, it would be incredibly hard (and possibly self-defeatingly expensive) to reshuffle a 120-stock portfolio every quarter, even if you were determined to do so.

Granted, the largely unchanging nature of the UK market’s list of largest companies means there is some continuity in the portfolio. Momentum investing, which this screen is heavily weighted to, also often works over periods of more than three months. For example, 12 of this quarter’s 20 negative momentum selections are returnees. But even when 46 shares appear consecutively – as is the case with our October picks – that would still mean placing 148 separate buy, sell, or short trades to switch to this quarter’s picks (see below).

This portfolio may have been constructed with no thinking in mind, but it requires plenty of work.

The counterargument to this is that by allocating 20 stocks per factor, the portfolio better captures each theme, and reduces the effect of outliers. One of the issues I have found with our quarterly Momentum Classics screen is that by restricting its ‘long’ and ‘short’ picks to 10 stocks each, it ends up concentrating on the most volatile equities in the market, which are exactly the kind of stocks that are liable to crash after a rally (or receive a price-raising takeover offer after a period of weak trading).

Indeed, if the third quarter’s results are anything to go by, a smaller portfolio won’t necessarily improve things. A 10-stock-per-factor version of the screen collectively underperformed the normal 20-stock one, regardless of whether dividends were reinvested. While this won’t always be the case, I feel less concerned that the portfolio is at risk of overdiversification and mean-reversion, and that a large size might be a smarter way to smooth out some of its spikiness.

I’m still not sure what to do about conflicts in the screen, such as the appearance of high-yielding value stocks Jupiter Fund Management (JUP), Ferrexpo (FXPO) and Centamin (CEY) on this quarter’s short-volatility list. The momentum strategy's high quota of stocks that have had takeover bids accepted – including Mediclinic (MDC), Euromoney (ERM), ContourGlobal (GLO) and Homeserve (HSV) – also carries with it some redundancy. But other issues feel more settled. The importance of dividends to UK stocks means it feels sensible to concentrate on total returns. And although re-balancing the entire portfolio each quarter (rather than by theme) might be impractical in the real world, it helps for the purposes of comparison.

More so than most screens in these pages, the No-Thought portfolio is a theoretical exercise. Heavy use of short-selling may have proved a boon during the past year’s sell-off, and the extreme volatility of early 2020, but it comes with added borrowing costs and all sorts of risks for a portfolio looking to build long-term wealth.

What the portfolio’s recent performance does suggest, at least to me, is that there are ways to hedge risk using just equities. Then again, it might simply reflect the UK stock market’s odd construction and biases.