Are you in search of an effective ‘system’ through which to build your portfolio? One option is momentum investing. Momentum investors in effect ride the crest of the wave of the most successful stocks or funds, aiming to jump from one holding to the next new performance leader. The Saltydog momentum portfolio outlined in our feature has certainly provided a relatively smooth route to a 52 per cent return over the past five years. But the momentum approach demands access to current data and ongoing commitment on a frequent basis. Many investors may struggle on both counts.
What strategy might you follow if, instead of buying the winners, you want to follow cheap losers in the hope of enjoying their recovery? Warren Buffett kept it simple when he advised investors to ‘be fearful when others are greedy and greedy when others are fearful’. But his advice, while sound, hardly cuts the mustard on specifics.
One possible approach was outlined in a fascinating cutting recently sent to me by a reader. It’s a short article from The Times dated 1978, in which the venerable financial journalist Margaret Stone back-tested a very simple contra-cyclical proposition: that funds which do very badly one year tend to outperform the next, so that if you buy last year’s losers you should often be picking up some of this year’s winners.
Stone is under no illusions about its universal applicability. ‘The investment background of some of the management groups does not convince me that their ugly ducklings of one year will be transformed into wonderful swans the next, no matter how well the market or sector selected had done’, she says. She therefore suggests limiting the strategy to the fund houses with the strongest capabilities.
Back in 1978, M&G fitted that bill pretty well, so she applied the rule to M&G’s funds over the previous six years. The starting point was a hypothetical £10,000 investment at the start of 1972 into the worst-performing M&G fund of 1971(M&G Equity), which was then switched in January 1973 to the dud of 1972 (M&G Property), and so on. By the start of 1978, the initial £10,000 had increased in value to an astonishing £50,723.
The worst performers did not invariably enjoy a big bounce, or even positive returns. In 1974 the hypothetical investment, by then worth £16,500, was moved to M&G American, and by the end of that year had shrunk again to just over £10,000. But in 1975 it rode the enormous recovery wave enjoyed by M&G Extra Yield, growing to more than £26,000. Extra Yield – clearly not a choice for widows or orphans – was the laggard of the house again the following year, but produced another impressive return of around 65 per cent for the worst-performer investment in 1977.
In contrast, a £10,000 starting investment into the best fund of the previous year, moved each year to the previous year’s top performer, had grown at the start of 1978 to a measly £11,671. In four of the six years it lost value; it was effectively kept in positive territory by a year invested in M&G Japan, when it grew by two thirds.
How would such a strategy have paid off over the past six post-crisis years? We recreated Margaret Stone’s exercise using Schroder as a pretty reliable fund management house, starting in January 2010 with a phantom £10,000 invested in Schroder Tokyo, the lame nag of the Schroder stable in 2009 (down 2.62 per cent).
The results are markedly less impressive than those for M&G in the 1970s, but our £10,000 nonetheless more than doubled to £23,429 over six years to the start of 2016. Moreover, it holds its own against £10,000 invested in Schroders’ top performers of the previous years, which would have grown to £19,977 over that time. That’s despite the fact that in two of those years – 2010 and 2013 – the top performer from the previous year posted a second outstanding performance far ahead of the previous year’s worst performer.
Interestingly, a one-year adjustment to the time period opens up a dramatic difference between the two strategies, reflecting the post-crash bounce enjoyed by sectors decimated in 2008. When we back-test for the six years to January 2015, the worst-performers investment powers away, growing by more than 200 per cent to £30,245, while its best-performers rival only just achieves half of that, at £15,953.
Clearly, few investors will be keen to plough their worldly wealth into a single underperforming Schroder fund each new year; and there’s certainly no reason to expect neat and tidy rewards from any such crude investment approach. There’s also a large element of luck in such an experiment: recent outcomes might have been very different, for example, if Schroders ran a commodities fund.
Nonetheless, we can learn the lesson that hard-hit funds are more likely on the whole to enjoy a rewarding bounce than current winners are to maintain their outperformance. In a well-diversified portfolio there’s surely room for both.
Faith Glasgow
This post was originally published on Money Observer HERE
