Those familiar with Fantasy Football will recognise many of the principles that underpin portfolio investment. Game participants, or managers, are given a notional amount to construct a squad consisting of 15 players, 11 of which can be chosen to form a team in any given week, with points awarded for their performance. The object of the game is to score as many points as possible. Those players that underperform can be transferred out and new ones bought in, subject to a budget constraint that changes as the market value of players rises or falls. More than one transfer per week incurs a penalty that reduces the points tally.
Choosing the initial mix
The first difficult decision a manager faces is the initial composition of their team. One of the most effective strategies is to pick players from highly ranked teams who have performed well in the past. However, a notional budget of £100mn does not go very far when the Tottenham duo of Harry Kane and Heung-Min Son, with initial valuations of £12.5mn and £10mn, respectively, are joined by Liverpool’s Mo Salah (£12.5mn), Chelsea’s Romelu Lukaku (£11.5mn) and Manchester United’s Bruno Fernandes (£12mn). Already almost 60 per cent of the transfer fund has been eaten up by just one-third of the squad and raises the question of whether we should rely on a few star performers or try to distribute the points more equally.
Such dilemmas are familiar to equity investors. Given an initial budget, how do they go about selecting a stock portfolio? There are a number of strategies from which to choose, but one of the easiest is to select those stocks that have previously performed well in the hope that this trend will continue. Suppose at the start of 2022 an investor wanted to put £10,000 in FTSE 100 stocks based on a strategy of picking the top five performers in 2021. Assume that our investor opts for a balanced portfolio in which each stock has an equal value weighting in the basket. They would thus construct a portfolio comprised of Ashtead (AHT), Meggitt (MGGT), Glencore (GLEN), Croda International (CRDA) and Royal Mail (RMG), buying £2,000-worth of shares in each company.
Obviously, the outbreak of the war in Ukraine has changed the investment landscape, but the object of the exercise is to compare the portfolio against the benchmark index. Unfortunately, three of the stocks in the portfolio (AHT, CRDA and RMG) have posted big declines exceeding 28 per cent in the course of 2022, although this has been partially offset by a sharp increase in the price of Glencore. This helps limit the overall decline in the portfolio to 'only' 12.5 per cent compared with a gain of 1.8 per cent for the FTSE 100 overall.
Clearly, this initial selection criterion was a poor one and highlights the old adage that past returns are no guide to future performance. Just as a week is a long time in politics, so a year is a long time in the markets, and closer inspection reveals that by end-2021 all five stocks in the portfolio were already below their highs for the year. In other words, they lost momentum over the course of 2021.
If our hypothetical investor wants to better capture momentum, perhaps they would benefit by looking at more recent trends. In Fantasy Football terms, this is akin to picking a team based on form – a short-term measure of performance based on recent games, rather than a long-term assessment of average performance. Based on data for the fourth quarter of 2021, the five best-performing stocks in terms of price were Ferguson (FERG), Auto Trader (AUTO), Segro (SGRO), Sage (SGE) and Royal Mail (RMG). Constructing a portfolio on the same basis as the previous one unfortunately results in even bigger losses, with a decline of 24.9 per cent year-to-date, thereby demonstrating the old sporting metaphor that form is temporary but class is permanent. It also illustrates the limitations of this strategy in the face of an exogenous shock. To compound the problem, Ferguson decided in March to move its primary listing to New York and it exited the FTSE 100 in May (although it retains a listing on the London main market with a standard rather than a premium listing). In Fantasy Football parlance, this is equivalent to losing a critical player in the team to an injury that renders them unavailable for selection.
The switching problem
Football managers are aware of the risk that players may suffer injuries or that one or more of their expensively acquired squad members will not deliver the goods. They must therefore weigh up whether it is worth holding onto an expensive underperformer, or an injured player, against cutting their losses. Equity portfolio managers face similar problems and in both cases it is important to find better-performing alternatives.
The downside to transferring out an injured footballer is limited, but this is not the case for equity investors where the new portfolio addition may fall sharply in price, while matters are complicated by the fact that they have the alternative of cash as a safe haven. Switching to a stock whose price subsequently falls produces additional portfolio losses, whereas simply holding cash has no adverse effect.
The underperformance problem is more difficult to deal with. A football manager/equity investor who wishes to remove an underperformer from their team/portfolio has the additional problem of having to deal with the opportunity cost of their choice. If the player/stock that is transferred outperforms more strongly than the new addition, this represents an underperformance relative to the cost of doing nothing (and in the equity case incurs trading costs into the bargain).
While the injury problem is common in football, it is less of an issue in the equity space: it is not often that a strongly performing stock such as Ferguson drops out of the index, raising the question of what should we replace it with. There are two obvious choices: either seek a company in a similar sector, such as Spirax-Sarco Engineering (SPX), or choose one whose performance in the fourth quarter (Q4) of 2021 was negatively correlated with Ferguson, such as Entain (ENT). Neither option would have boosted the portfolio’s performance. Indeed, there is very little that can be done to rescue the portfolio given the poor performance of all the other components. In football parlance, the team as a whole was struggling and the injury to a key player did not have a material impact on performance. Fans of Manchester United may see parallels in this season’s performances by Paul Pogba.
In such a situation, the investor should consider wholesale changes to their portfolio, which will incur a penalty in the form of transaction costs but may be worthwhile if the new additions generate returns in excess of these costs. On the basis that the invasion of Ukraine began on 24 February, suppose our investor decided to rebalance their portfolio at the start of March and, undeterred by the failure of the momentum strategy earlier in the year, they picked a basket based on the best performers over January and February. This results in a portfolio consisting of BAE Systems (BA), Anglo American (AAL), Shell (SHEL), British American Tobacco (BATS) and Endeavour Mining (EDV). Bear in mind that since the original portfolio based on Q4 2021 momentum was 14.5 per cent down at end-February, the new investment pot is a lot smaller. The good news is that the portfolio switch does stem the losses, with the new basket rising by 1.8 per cent even after accounting for transaction taxes. Obviously this is not enough to offset the losses in the original portfolio over January and February, leaving us 13.5 per cent down year-to-date (admittedly better than a loss of 24.9 per cent on an unchanged portfolio). For the record, it is possible to have substantially outperformed the index with a basket comprised of Shell, Glencore, BAE, Standard Chartered (STAN) and BP (BP.), which would have generated a healthy year-to-date return of almost 35 per cent.
This highlights that judicious portfolio switching is necessary to optimise returns. Had the manager currently leading the Fantasy Premier League global rankings left their team unchanged following their initial selection, their points tally would be 36 per cent lower and they would be placed bang in the middle of the distribution. Having constructed a high-scoring team based on historical performance, a passive attitude towards team changes would result in an average performance – not bad but not standout. This is generally true in the investment world, too. Index investing is designed to match, but not beat, the benchmark. At a time when markets are rising, this is a reasonable strategy. But over the past six years the FTSE 100 has tended to move sideways and it pays to look for ways to beat it. Unfortunately, as our experience with momentum strategies has shown, that is easier said than done.