Momentum investing beats index-trackers

A momentum approach to equity investing – buying shares that have been good performers and selling poor performers – could have produced much higher long-term returns than index-tracking, value investing or backing smaller companies, according to a study by Credit Suisse and London Business School (LBS).

A strategy based on buying the previous year’s top-performing shares could have delivered annualised returns since 1900 of 14.3 per cent in the UK, well ahead of the market’s 9.5 per cent average.

This “winner” effect was found in most of the 19, mainly developed, markets analysed in the 2011 edition of the Credit Suisse Global Investment Returns Sourcebook.

“Over the long run, [momentum investing] has generated volatile but strikingly good performance,” it says.

The UK’s “momentum premium” of 1 per cent a month – the average extra performance of share winners over losers – has also been relatively high compared with other markets.

In the US, for example, the monthly premium was less than half the UK’s, while France and Germany were also lower. Japan was the only market where this trend-following investment approach appeared not to work at all.

By contrast, these other major markets were often found to be better than the UK for value or smaller company investing.

Japan’s 6.2 per cent annualised “value premium” – the degree to which value shares outperformed growth stocks – was the highest of the 19 markets in the study, and compares with value premiums of 1.7 per cent in the UK and 1.1 per cent in the US.

Meanwhile, the smaller companies’ effect – returns in excess of larger companies – has been most pronounced in the US, at 0.72 per cent a month against a below-average 0.22 per cent in the UK.

The profitability of momentum investing is commonly put down to share prices taking time to fully reflect new information.

But Professor Paul Marsh of LBS, one of the authors of the study, warns that while it has been a winning long-run strategy, momentum tends to disappoint when markets change direction suddenly.

In 2009, for example, when markets bounced back strongly after the credit crisis, a momentum investor would have missed the start of the recovery and lost out as shares that had previously fallen the most, such as the banks, rose the most.

“Investment styles don’t work every year and can be out of fashion for many years,” he warns.

The stock turnover implicit in a momentum strategy can also mean high trading costs, although private investors could still apply its basic message in their portfolios.

“If you’re thinking of selling some investments, then sell the losers,” suggests Prof Marsh. “If you’re buying, then, at the margin, favour shares that have already gone up.”

Investors who believe the bull market will continue could benefit from a momentum approach, he says, while those expecting a market reversal might want to avoid this strategy at the moment.

It could also be a good time to buy value stocks, he says, as they have been underperforming growth investments in recent years. Similarly, the higher returns enjoyed by smaller companies in the past decade could mean it is now worth favouring blue chips.

Barclays FTSE100 Trend is one of the few momentum funds available to private investors apart from momentum hedge funds. However, financial advisers say that momentum can also be a factor in other funds’ investment approaches.

Mick Gilligan, head of research at Killik & Co, a wealth manager, says these include Standard Life UK Equity Unconstrained and Investec UK Smaller Companies, while Ben Yearsley of Hargreaves Lansdown points to Artemis’s European Growth and Global Growth funds.

There is a much wider choice of value funds, including M&G Recovery and Fidelity Special Situations in the UK, according to Bestinvest, the adviser. Ignis Argonaut European Income and Jupiter Japan Income are two overseas value plays suggested by advisers.

They add that value funds are not always labelled as such, while many may confusingly have “growth” in their title.

Yearsley says: “If investors are worried about style bias, they should try to understand a fund’s approach – if not, just try and find the best manager and hope he buys the best stocks.”