Defensives and momentum still win

Equities enjoyed a good second quarter, with the FTSE 350 rising 20 per cent. You’d expect, therefore, that high beta stocks (those most sensitive to moves in the aggregate market) would have done well. And they have. My portfolio of them rose 41.2 per cent in the quarter, thanks in part to huge gains on Boohoo and Hochschild.

In the longer-term, however, investors pay a high price for such short-term out-performance. In the last ten years, my high-beta portfolio has underperformed the FTSE 350 by over 50 percentage points.

This isn’t a quirk of my portfolio. It’s part of a general trend. Economists at AQR Capital Management have shown that many other high-beta portfolios – and not just of equities – also underperform over the long-run. There’s a reason for this, they say, which probably applies to the UK too.

It’s that many investors cannot borrow as much as they’d like – either because banks won’t lend or because fund managers’ mandates forbid them from doing so. Such investors cannot therefore express their bullishness by borrowing to buy shares generally, as orthodox financial economics says they should. Instead, they buy high-beta stocks in the hope that these will give them geared exposure to a rising market. In piling into them, however, such stocks become over-priced and so they under-perform on average over the longer-run.

You should not therefore be kicking yourself for missing out on the big rises in high beta stocks. And you should be sceptical of anybody who did buy them. On average, backing beta does not pay.

The counterpart of high-beta stocks doing badly is that low-beta ones do well. Again, this is what we’ve seen recently. My portfolio of them only slightly under-performed in Q2, which means it has actually risen in the past 12 months. This is not what you’d expect from conventional theory: because the portfolio has a positive beta, it should have only fallen less than the general market. It’s done better than that. Thanks in part to this, the portfolio has now beaten the market over the last five and 10 years, despite having done badly in much of 2018 and 2019.

This is no quirk of this particular portfolio. For one thing, defensive sectors of the market have done well in the past 12 months: tobacco, food retailing, utilities and pharmaceuticals are all up. And for another, we have abundant evidence from around the world that defensive stocks do better than they should. The longer-term outperformance of defensives is a fact which is robust to differences in definitions and data.

Defensives, though, are not the only category of share for which we have long-term evidence of out-performance. We know that momentum shares on average do well – a fact which is also not confined to the UK and is robust to different definitions. This fact held true in Q2: my momentum portfolio beat the market, with especially big gains in ITM Power, Ceres Power and Games Workshop.  

This means that it has beat the market over the past five and ten10 years. Its 47 per cent gain in the oast five years (even excluding dividends) has been beaten by only ten of the 221 funds in Trustnet’s database of UK all companies’ unit trusts. And barely 10 per cent of unit trusts have beaten its 10-year record.

If this doesn’t shock you, it should. It means that you could have beaten 90 per cent of funds simply by buying the 20 biggest-rising stocks over the previous 12 months. Which means that most of what most fund managers do actually subtracts value from a no-brain strategy. Which should raise a deep question about everybody’s investment processes: what exactly is it about these that does add value?

The counterpart of positive momentum doing well is that negative momentum does badly. And over the longer-run this has indeed been the case. In the past five years, my negative momentum portfolio has lost almost 50 per cent.

What both performances tell us is that investors often cleave too strongly to their prior beliefs about a stock and so do not respond sufficiently to new. When they see a company announce good news, they think it a flash in the pan from an otherwise average company and so don’t bid up its price sufficiently, causing it instead to drift up as reality gradually dawns. And when a company announces bad news, its holders don’t sell in the hope they will break even somehow later.

All this reminds us that we must sell losing stocks. If you hope for a rebound you will often be disappointed.

That said, there were few disappointments for holders of loser stocks in Q2. My portfolio beat the market thanks in part to 60 per cent-plus gains in Fevertree, Drax and Playtech. This, though, tells us more that sentiment was bombed out at the end of March rather than that backing losers is a generally good idea. It’s not.

There is, though, a curiosity about Q2’s rally. If it were based on hopes of a V-shaped economic recovery we would expect value stocks do have done especially well as these comprise stocks carrying lots of recession risk: my value portfolio held Carnival, Cineworld and International Consolidated Airlines, among others. But in fact, this portfolio actually underperformed in the quarter. Yes, Royal Mail and William Hill did well, but many high-yielders such as Tui, Hammerson and Carnival barely rose.

You could read this as a reason for optimism. It suggests that the market’s rise is due more to a correction of excessively negative sentiment than to any actual economic optimism: a rally led by Games Workshop, Fevertree and Royal Mail is not exactly a sign of irrational exuberance. Which suggests that if we do get decent evidence of the V-shaped upturn expected by the Bank of England’s Andy Haldane then the market rally should get a second wind, with cyclical stocks leading the way.

Such futurology, though, is not the point of this exercise. If anything, the exact opposite. What I’m trying to do here is produce evidence for whether particular strategies work or not. I’m doing this in real time, thus avoiding selection or hindsight biases. And I’m doing it without using individual judgment: investing should not be a matter of ego. And the evidence tells us that two strategies – defensives and momentum – do work on average, and therefore that we don’t need especial skill to beat the market.