Rob Gleeson, head of research at FE, says that it is even more important than diversifying geographies given the globalised nature of the world economy which means that major stock markets are more and more correlated. However, it is hard for investors to avoid being seduced by simple strategies that seem to have a lot going for them.
Here we look at why neither a buy and hold, contrarian nor value strategies is sufficient and investors need to blend approaches to be able to outperform in the longer run.
1. Low turnover isn’t important
One of the approaches that investors first come across is the philosophy of “buy and hold”. This is often flagged up as the approach that has made Warren Buffett so rich, and Buffett himself is evangelical about it.
There are a number of reasons given for following this approach. One is that investors who buy and hold are more likely to be true to their analysis rather than following more ephemeral trends. On this way of thinking investors will do better to stick to fundamental analysis and avoid more capricious fashions.
Another idea is that investors can reduce their trading costs by buying and selling less frequently and thereby increase their returns. Thanks to the power of compounding, the effects of higher fees on a portfolio are huge over the longer term.
This latter way of thinking appeals to the conspiratorial idea that active managers are skimming unnecessarily from your savings by trading more than they need to.
However, there are a number of glaring examples of managers who have high turnovers in their portfolios and are extremely successful.
Most notable is Anthony Bolton, probably the most famous and well-regarded fund manager in the UK.
Bolton ran Fidelity Special Situations between 1979 and 2007 and smashed the returns of the FTSE All Share over that time.
Over the last 20 years alone of his management the fund made 1492 per cent as the FTSE All Share grew just 685.5 per cent, according to data from FE Analytics.
Performance of fund 1987 to 2007
Source: FE Analytics
Yet he ran the portfolio the whole time with a turnover of around 70 per cent, meaning that 70 per cent of his holdings were sold every year. This is much higher than most managers, and directly opposed to the philosophy of buy and hold.
The new manager of Fidelity Special Situations Alex Wright, the best-performing manager in the UK over the past five years, also has a high turnover style on the Fidelity Special Values trust of between 60 and 80 per cent.
Performance of manager vs peers since 2008
Source: FE Analytics
Both managers have produced significantly better returns to investors than their peers with a high turnover style.
2. Contrarian strategies don’t work
Research from broker Liberum shows that contrarian strategies don’t work. Buying the most unloved stocks by analysts each month has generated no obvious outperformance over the longer term.
In fact, during the crisis years of 2007 and 2008 buying the most hated stocks underperformed.
The risk with following a contrarian strategy and buying what everybody else is avoiding is that sometimes everybody else is avoiding something for good reason.
The risk is most evident with the mining sector in the current market. Miners have been out of vogue since 2011 when over-expansion of capacity and a slowdown in China caught up in them.
Performance of indices over 5yrs
Source: FE Analytics
Since last spring more and more managers have been looking at the sector and considering whether it’s time to make the contrarian call and buy in.
So far you would have been wrong to buy in judging by the returns to the indices – the FTSE World Mining index has lost a further 7.08 per cent since last May as the market has been essentially flat.
Performance of indices since May 2013
Source: FE Analytics
Investors can always argue that in the long run their bet will come off. This may be so. However, as Keynes famously said, in the long run we are all dead.
A manager needs a huge degree of skill or luck to make contrarian call after contrarian call correctly without it coming back to bite them.
3. Value strategies underperform in bear markets
Research from broker Liberum shows that you could have beaten the small cap market with a value style since 2000.
Their data shows that buying the cheapest quartile each month by forward P/E [expected price to earnings] ratio would have generated significant outperformance.
However, in times of market stress this style would have let you down. During the crisis of 2007 to 2008 following a value strategy underperformed the market.
Liberum’s momentum screen did better even in the crisis years, however, but this does not mean it is the panacea.
Momentum strategies involve buying what has recently done well, and there is strong evidence to suggest it often outperforms.
However, the recent sell-off in tech stocks shows what can happen when markets suddenly change direction.
ASOS, one of the flying stocks of the preceding decade has lost 37 per cent since the end of February, and internet retailer Ocado is down 36 per cent.
One of the funds hit by the former’s bad patch is FE Alpha Manager Harry Nimmo’s Standard Life UK Smaller Companies fund.
Nimmo and his team incorporate momentum strategies into their stock selection process and have kept hold of ASOS despite its growing outside the remit of most small cap funds.
The portfolio is one of the best-performing funds in the sector over the past decade but is bottom quartile over the past year as its style has gone out of fashion.
Relative performance of value vs momentum in 2014
Source: FE Analytics
Data from FE Analytics shows that value strategies in the UK market have significantly outperformed momentum strategies in the recent sell-off.
