Momentum works until it doesn’t, according to Scottish Investment Trust manager Alasdair McKinnon, who said that some investors may be falling into a herding trap. 
In the company’s interim results, McKinnon noted that his portfolio was deliberately run with a contrarian bias for this reason.
“At the core of this philosophy is a recognition that investors are not, in aggregate, dispassionate calculating machines but instead retain human emotions,” McKinnon (pictured) said.
“As humans, we have many differing emotions, desires and motivations but one apparent constant, which is maintained across cultures and geographies, is a desire to be part of the group.”
While this has benefitted society greatly historically, with plus sides including division of labour, specialisation and economies of scale, in financial markets the crowding instinct does not necessarily translate.
“Crowds naturally gravitate towards what has recently been successful and shun what has recently been unsuccessful,” the manager said.
“The crowd voice, which is always alluring, is driven by individuals who seek to align themselves with success and disavow failure.”
This has picked up pace in recent years, with the MSCI World Momentum index outperforming the MSCI World Value index by 33.88 percentage points.
Performance of indices over 3yrs
Source: FE Analytics
However, McKinnon warned while that strategy has worked more recently, as we get closer to the end of the bull market it will not work forever.
“By the time an investment has performed sufficiently well – or badly – for it to become an accepted wisdom, conditions are ripe for the trend to change,” he said.
“It is this momentum mentality which creates the business cycle and the numerous bubbles – and subsequent busts – which have bedevilled investment markets.”
Currently, investors are exhibiting remarkably low levels of scepticism about ‘hot’ investment themes such as the giant US FAANG stocks (Facebook, Amazon.com, Apple, Netflix and Google).
“It is particularly in the technology area, which mentally transports us back to the late 1990s when similar enthusiasm reigned – it didn’t last,” the manager added.
The collapse of hedge fund Long-Term Capital Management (LTCM) in 1998 and the subsequent central bank response, helped create the conditions for the dotcom bubble in the early 2000s.
Once the hedge fund management firm was bailed out investors became “feverish” with sales of IT hardware and services particularly booming both to salve the impending ‘Millennium Bug’ and due to an increased desire for personal computers, McKinnon noted.
Performance of MSCI World index from Jan 1998 to Jan 2004
Source: FE Analytics
However, companies that benefited from this trend became valued as if the good times would never end, which ultimately they did, as the chart shows.
“Things are different today, but in some ways they are the same. Once again, investors are excited by concept investments even if the most speculative of them all, the cryptocurrencies, have already disillusioned their fan club,” the manager said.
While things like cryptocurrencies may seem irrelevant to an equity investor, they represent a proxy for the ease of financial conditions and a willingness to suspend disbelief in search of a speculative return, he added.
Meanwhile, investors continue to reward what is known as an ‘eyeball’ metric, which in the late 1990s was generating unprofitable user views but in the modern era appears to be unprofitable user growth, he added.
McKinnon noted: “Internet shopping, food delivery, ride hailing services, music and video streaming, to name just some, are all subsidised at the point of use by investors.
“Meanwhile, investors show scant concern that the premium smartphone boom has peaked and have only recently started to consider that companies operating in the ‘Wild West’ space of internet advertising may be about to meet the posse – courtesy of the Facebook data scandal.
He added: “The data scandal involving Facebook and Cambridge Analytica shook the entire technology matrix. Expectations remain too high in this area and the threats from politicians, regulators and disrupted incumbents continue to be brushed off. We have minimal exposure to this area.”
Over the six-months to end-April, Scottish Investment Trust delivered an NAV total return of 1.9 per cent versus a 0.6 per cent fall in the MSCI AC World index.
Performance of fund vs sector and benchmark over 6months
Source: FE Analytics
McKinnon has been manager or acting manager of the £852m investment trust since 2014, during which time the portfolio has returned 69.51 per cent.
“We do not attempt to follow investment fashions and instead seek investments in which we can foresee long term upside,” the manager said. “We actively seek unpopular areas because this is where the balance between risk and reward can be most favourable.”
Since taking over the portfolio, McKinnon has increased the focus on high conviction ideas, reducing the number of holdings from 100 to 55, with little exposure to areas such as technology, whilst favouring out-of-favour areas, such as oil.
Shares are on a 7.8 per cent discount to net asset value (NAV). It is 4 per cent geared, has a 2.3 per cent dividend yield and ongoing charges of 0.47 per cent, according to the Association of Investment companies (AIC).