Value stocks or momentum stocks? Why not both?

Open your Isa account and take a quick look at the funds you hold. How many of them are value plays? How many of them are momentum funds? How many are fully focused on small-caps? Almost none? If so, your portfolio might not be anywhere near as good as it could be.
Look to the past and you will see that the best-performing strategies over almost any longish period of time are value, momentum and small-caps. Take value. In his book Deep Value Investing (to which I wrote the foreword) Jeroen Bos chucks out some numbers.
If you had put $10,000 into stocks with a high price/earnings ratio at the beginning of the 52 years leading up to 2003 you would have had $793,558 by 2003. Sounds good. But had you instead put it into stocks with a low price/earnings ratio, you would have had $8.1m. Much better.
That isn’t just in the US either: value investing has beaten growth investing in most countries over the long run. In his book The Future is Small (rather embarrassingly I think I wrote the foreword to this one, too) Gervais Williams offers similarly impressive numbers, in his case on the small-cap effect.
If you had put a pound into the UK market as a whole in 1955 you would have had £1,070 by 2013. Not bad. Had you tracked the Numis Smaller Companies Index, however, you’d have ended up with £4,907. Again, much better.
On to momentum investing, which basically means buying whatever’s going up and sticking with it until it stops going up and hoping for no nasty crashes along the way.
Here it is worth looking at data from the big names in investment academia: Elroy Dimson, Paul Marsh and Mike Staunton. They showed that from 1900 to 2016 the stocks that outperformed the index over a 12-month period tended to beat the market again in the subsequent 12-month period. The top fifth of performers outdid those in the bottom fifth by a fairly stunning margin – in the US 17.5% to 9.5% and in the UK 14.1% to 3.6%.
Investing should not be this simple. That it is, as Brian Dennehy of FundExpert points out in his book Clueless (nothing to do with me), is “almost insulting” to the industry. But think about the way people behave – constantly getting caught up in the greed and fear cycle regardless of the information in front of them – and the success of momentum strategies does make some intuitive sense.
The fund management industry makes investing like this difficult
So here’s the question: if this stuff works, why doesn’t everyone do it for their retail investors?
The answer is in part down to the usual human frailties of fear, greed and so on, but it is also about the way in which the fund management industry works. We all like to think that we are in markets for the long term. But that doesn’t mean that fund managers get five years or more to show that what they do works. They tend to get a couple of years at the most.
Strategies that work over the long term but not always over the short term aren’t much good to them, particularly in an industry where compliance rules everything. (Value investing comes off worst here, as the strategy requires levels of patience the market just doesn’t have.)
In the case of momentum investing, the explanation might be even more simple: fund management companies are mostly paid a percentage of the assets they have under management. In the main, it is easier to get in new assets by getting a good marketing manager to tell an interesting stockmarket story to investors than it is to grow by performing well. But what kind of a marketing story would include the words “we just buy stuff that is already going up” or would admit that once you’d figured out how to calculate a moving average you were kinda done? Quite.
And possibly more pertinent these days, how much would you the investor pay for a manager telling that story? Hint: not very much at all.
On the other hand, while this kind of investing might not be theoretically difficult, you really don’t want to do this yourself. While you don’t have to do any boring balance sheet analysis of the firm you might invest in, there’s still research, admin and an awful lot of expensive trading involved in tracking the best performers in a market and moving in and out of them over various timeframes.
How to invest in both value stocks and momentum stocks
What you want, then, is a cheap provider to do the boring bits for you. There is some movement in this area. iShares has launched a few exchange traded funds – you can take in the whole world with the iShares Edge MSCI World Momentum Factor ETF, for example.
Alternatively, Saltydog, a newsletter producer, has suggestions for a fund-based momentum portfolio and Dennehy’s FundExpert provides what it calls “dynamic fund ratings” to subscribers. You buy funds with five stars (these are the ones that have been in the top quintile over the previous six months) and replace every six months.
Dennehy has, he says, back-tested this to 1994 in the four most popular fund sectors and has found a better than 90% incidence of 40%-plus outperformance over every five-year period.
The often pointed out problem here is that momentum investing can’t save you from a crash: if the market turns suddenly, you will go down with it. You can combat this by keeping an eye on value as well, perhaps, as Charles Ekins of the TB Enigma Dynamic Growth Fund suggests, by mixing trend following with value. This means selling out not when the trend turns, but “when value disappears”. Dennehy would use a stop-loss strategy to halt sudden losses but he also challenges the idea that crashes hurt momentum investors more than most.
Take 2008, he says. From January to the low in that year, the FTSE 100 fell 42%. His momentum portfolio fell 46%. However, it also moved back into positive territory before the FTSE 100 and was outperforming again by September 2010. Also worth noting is that from 1994 to 2015, the FTSE 100 had 101 negative months. The Dynamic Fund Portfolio had only 86.
Delightfully simple and attractive as all this sounds, I am not suggesting that you pour all your money into momentum. Like everything, it can’t possibly always work and nor can financial history always forecast the financial future. But I do believe that thinking about putting part of your portfolio in momentum and a part in value (they often move in opposite directions) might well help you outperform the professionals over the long term. Which would be very satisfying for you – and for me.
• This article was first published in the Financial Times

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