If you’re looking to start 2018 with a different yet exciting investment approach, you may want to try a spot of no-brain investing. If this suggests an index or tracker fund of some sort, you’d be way off the mark. What you would be doing is following the approach of UK financial journalist, Chris Dillow. For some years now he has been running six simple portfolios, using a straightforward approach that can be followed by most. And some of the results he has obtained are nothing short of amazing.
Chris has a few simple rules that determine the shape of each portfolio. All shares are listed on London’s FTSE, and are UK shares with a market cap of over £500 million. All six portfolios are made up of twenty different shares, and although he only mentions this in respect of his "Momentum" portfolio, some of the portfolios are probably rebalanced every quarter. Others are more likely to be revised on an annual basis.
Speaking of his Momentum portfolio, this is undoubtedly the star of the show. It comprises the 20 biggest risers of the past 12 months, and as mentioned is updated every quarter (probably on a rolling 12-month basis). In the past 12 months, this portfolio has grown by 34.1%, and over the past five years it has shown an amazing 156.4% rise. Even the ten-year return of 196.3% is not to be sniffed at.
As Chris points out, momentum investing has a long and successful track record. In an article published in the Journal of Finance in 2001, Jegadeesh and Titman showed that, since the 1960s, momentum stocks had beaten the US market. Other researchers also detected momentum effects in international stock markets, as well as in commodities and currencies.
Dillow notes that most investors are wary of momentum investing, despite its impressive history. The biggest cause of unease may be down to the fact that the reasons for momentum success are unclear, and don’t seem to be the result of investors taking on extra risk. Perhaps, as Dillow speculates, knowledgeable investors steer clear of momentum shares, and as a result their profits have not been bid away.
The results of the momentum portfolio for the past 12 months may be explained by the long-running bull market in the UK. But the persistence of this effect is impressive, and is something I will explore in a later article. For now, we can reflect on Dillow’s tongue-in-cheek comment that the hours spent analyzing shares are obviously wasted; investors should simply buy shares that have recently jumped in value.
The negative momentum portfolio is made up of the biggest losers of the past 12 months. If momentum stocks show regular growth over time, one would expect negative momentum stocks to show a long-term declining trend. This is pretty much the case for Dillow’s portfolio, which shows negative returns over the past 3 and 5 years. However, in a surprising turnabout, the portfolio returned 14.2% over the past 12 months, comfortably beating the FTSE 350 index which grew by 8.8%. However, this is almost certainly an anomaly and one should not expect a continuance of this outperformance.
The 20 highest-beta shares also performed handsomely over the past 12 months, returning a healthy 21.7%. This is of course in line with accepted finance theory, which suggests that high-risk shares, i.e. those which show the greatest degree of price fluctuation (compared to the stock market as a whole), should deliver the best returns. But the theory falls flat over 3, 5 and 10 years, with returns of 12.6%, 14.3%, and -3.1%, respectively (compared to 19.0%; 35.5% and 27.4% for the FTSE 350 index).
Dillow’s low-risk, low beta portfolio turned the theoretical risk-reward relationship on its head. With price fluctuations below those of the market as a whole, this portfolio should not have beaten the FTSE 350 index. Yet it did just that, returning 13.8%; 38.7%; 51.6% and 66.8% over 1, 3, 5 and 10 years, respectively.
This is an interesting finding, and supports the criticism levelled against beta that it is not a good indicator of market risk. Around the turn of the 20th century Fama and French showed that there was little if any relationship between beta and share returns, and these results mirror those findings.
Perhaps market analysts, indoctrinated into the cult of beta, ignore low-beta shares in the expectation that they will underperform. As with momentum shares, this lack of interest may have meant that low-beta profits were not traded away.
Dillow selects his 20 value stocks on the basis of their dividend yields, i.e. those with the highest percentage dividend yields over the past 12 months. The logic is that the dividend yields are high because the shares are out of favour, and their prices are therefore depressed.
The market seems to have got the prices right this time around, however, as the value portfolio underperformed last year. Twelve-month returns were a negative 0.6%, although the 3-year returns of 26.7% were almost eight percentage points above the FTSE 350, and the five-year returns of 62.2% beat the FTSE by a whopping 27 percentage points. But, perversely, over 10 years the value portfolio posted a negative return of almost 19%.
This approach is reminiscent of the ’Dogs of the Dow’ theory that was very popular in the early 1990s. The strategy entailed buying, each year, the 10 stocks in the Dow Jones 30-stock Industrial Average that had the highest dividend yields. Academics tested the theory, and found that since the 1920s the ‘Dogs of the Dow’ had beaten the overall index by 2 to 3 percentage points each year, despite not involving any additional risk.
As a result of these findings, by the mid-1990s more than $20 billion had been placed in ’Dogs of the Dow’ funds. However, the much-publicised findings were the funds’ undoing; as demand for these shares increased their returns shrunk, and for the last five years of the 1990s the ’Dogs’ funds underperformed the market. It may be that the ’Dogs of the Dow’ curse still hangs over the markets, although Dillow’s portfolio did post impressive 3-year and 5-year returns.
Dillow’s final portfolio consists of the 20 largest FTSE stocks by market capitalisation. This is contrary to Fama and French’s findings that, while beta was not well-correlated with stock returns, a size effect was detected in that small-cap shares were found to regularly outperform the market. Perhaps Dillow’s large-cap portfolio was based more on hope than judgement or, as he points out in respect of his general approach, as a means of testing alternative hypotheses. This approach does not appear to have enjoyed huge success; a 12-month return of 10,4% did beat the FTSE 350 index return of 8.8%, but this performance could not be sustained over 3, 5 and 10 years where the FTSE 350 index was the winner.
As mentioned above, Chris Dillow is not suggesting that any of his portfolio approaches should be seen as new investment strategies. However, in imaginative and often contrarian ways, he has tested accepted finance theory and found it wanting in a number of areas. This may present opportunities for any enterprising investors who are prepared to follow in his footsteps.
Momentum Surges Again, by Chris Dillow. Investor’s Chronicle, Volume 203/2581
AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.