Simplicity works in investment management, and momentum investing is simple ...
KEY POINTS:
In the last few years the investment management scene has become increasingly polarised between, at one end, the investors who search for active managers who can deliver outperformance, popularly known as alpha. At the other end are the cynics who put down outperformance in most cases to luck and thus advocate low-cost tracker funds which will deliver the market return; that is, index funds.
Leading the charge for the active camp are the hedge funds, the best of which seem to be run by ultra-intelligent maths or science graduates presiding over a black box computer model designed to filter large volumes of information into profitable trades.
That's the popular view of hedge funds and is probably why they are able to charge management fees of 2 per cent of assets managed plus 20 per cent of profits. However, reality may not be so flattering.
In fact, according to the latest work from London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton (DMS), writing in this year's Global Investment Returns Yearbook (GIRY), one of the simplest investment strategies, following a trend and known as "momentum investing", is not only popular among the whiz kids but, shock and horror, it actually works.
The GIRY was first published in 2000 for Dutch banking giant ABN Amro by the three professors. The core of the yearbook is long-term investment return data from 1900 to 2007 for short-term government bills, long-term government bonds, shares, inflation and exchange rates, for 17 of the world's largest stock markets representing 85 per cent of total equity market capitalisation.
The yearbook is the global authority on long-run investment returns and foreign exchange performance. Besides showing us where we should and shouldn't have had our money every year, the GIRY provides a detailed analysis of one or two key investment themes.
In previous years, the GIRY has looked at whether investors can make higher profits by investing in companies based in higher growth economies and how dividends forecast equity returns.
Last year's topic was especially relevant to New Zealand investors as it looked at the attractiveness of the guaranteed investment return products so popular with financial advisers locally. The professors concluded that, yes, guaranteed products did work so you could invest in shares with little or no risk of losing your money, but ... the costs of these products was so high their performance after fees would be little better than money in the bank. Good common sense, unbiased research for Mum and Dad.
This year, the focus is momentum investing, what it is, whether it works and its relevance to institutional and retail investors.
Momentum investing is a pretty easy to understand strategy and, in its most simple form, doesn't require a great deal of effort or grey matter. All it involves is buying those stocks that have gone up in the hope that trend will continue and, conversely, selling those which are going down.
The professors point out that while we might not know what momentum investing is, we might still do it or some variation thereof. For instance, all those people who aren't investing at the moment "because the market is going down" are using momentum. Whether it's to their advantage or not is another question.
Another example is the stock market "rule of thumb" of "letting your profits run" and "cutting your losses" early. In addition, many professional investors are involuntary momentum traders because they are evaluated relative to a size-based benchmark, such as Britain's FTSE 100.
They tend to buy stocks as they drift above the size threshold for large-cap index membership and to sell those that drift below the size threshold; they unwittingly benefit when there are momentum effects in the market. "Growth and value investors", too, are indirectly exposed to momentum effects, with growth investors benefiting from momentum and value investors suffering. Whatever their style, the momentum "story" is thus of considerable relevance to the investment community.
What makes momentum investing all the more fascinating is that efficient market theory suggests that such a simple system shouldn't work. But the professors find that it does, with one caveat. Their study of momentum goes back to 1900-plus for all 17 stock markets in their sample.
At the end of each month, they sort all the stocks in the total portfolio into the highest performers over the previous six months and the lowest performers over that period. They buy the top 20 per cent and sell short the bottom 20 per cent, hold them in a portfolio for six months then repeat the process.
They show that momentum investing was profitable in most markets, with only Sweden recording a negligible gain. In a UK study where the professors limited the study to the 100 largest stocks, the portfolio of winners returned 15.2 per cent a year whereas the portfolio of poor performers returned 4.5 per cent a year. This difference is quite significant : 1 ($2.55) invested in the winners grew to 4.2 million by the end of 2007 while the laggards compounded to 111.
This all sounds great until you realise that momentum investing involves huge turnover of portfolios to such an extent that, for all but the biggest investors, it would cost too much.
Apparently, hedge funds account for a disproportionate share of the turnover on the US and London exchanges - this is probably why. To give investors a feel for what a momentum portfolio in the UK would look like today, the professors highlight Rio Tinto, BHP and lots of other resource stocks as featuring in the winners' portfolio over the last 12 months.
Similarly the losers' portfolio would "short" banks, house builders and airlines.
The most interesting aspect of momentum is that such a simple strategy still works when everyone knows about it. Perhaps the next evolution in the momentum story might be a momentum exchange traded fund listed on the London stock market so that smaller investors can play the game too. That would be a good test of the robustness of the strategy.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free.