A very simple investment strategy, buying winners and selling losers, proved to be the best performing of all. With simplicity comes puzzlement: “In a well functioning market it ought not to work” say the authors of the study Paul Marsh, Mike Staunton and Elroy Dimson of the London Business School.
Called “momentum investing in equity markets”, the strategy delivers “striking” and “remarkably persistent” excess returns
The research, was published as part of ABN Amro’s latest Global Investment Returns Yearbookl. It examines the efficacy of systematic momentum investing; simply buying the stocks that had performed best over a prior time period and shorting those that had performed worst.
The team created two portfolios, one based on the 20 best-performing equities in the previous 12 months and the other the 20 worst performers using data on the UK’s 100 largest stocks since 1900. These portfolios were then re-calculated every month. The portfolio of winners produced compound annual returns of 15.2 per cent, turning £1 into more than £4.2m (€5.6m, $8.2m) by the end of 2007. In contrast, the portfolio of laggards returned just 4.5 per cent a year, turning £1 into £111.
The gulf was wider when the team used data from the entire London market since 1955; the portfolio based on the previous 12 month’s best-performing stocks returned 18.3 per cent a year, against 6.8 per cent for the erstwhile worst performers. The divide was starker when the portfolios were constructed on an equal-weighted, rather than market cap-weighted basis.
This momentum premium also appeared to hold abroad; it got positive returns from each of the 16 other countries they crunched post-2000 data for, with winners outperforming losers by 4 per cent a year in the US, 21 per cent in France and 39 per cent in Germany.
An investment approach based on this strategy would not be straightforward to execute. The research found portfolios need to be turned over regularly, adding to transaction costs, while smaller stocks may be difficult to short.
The academics argue it has widespread repercussions, with virtually every investment manager either betting in favour of momentum – from trendfollowing hedge fund managers to long-only managers who let winners run while cutting losers and engaging in “window dressing” of their portfolio – or, in the shape of small cap or value investors, betting against it.
“Every investor we have come across has, explicitly or implicitly, used a momentum or counter-momentum strategy,” said Prof Marsh. “[Consequently] people can look like a genius by accident or they can look a fool when they are quite smart.
“Active managers who ignore the momentum effect do so at their peril.”
The findings appear to run counter to a welter of studies, including the ABN yearbook, which suggest that small cap and value strategies tend to outperform over time, adding to the mystery.
Source: Ignore momentum at your peril by Steve Johnson, Financial Times