Why not go ‘bonkers’ with your portfolio?

It’s a “Bonkers portfolio” with returns to match, according to FundExpert.co.uk, a website run by financial advisers Dennehy Weller & Co. They calculate that if an investor had begun in September 1995 by buying the fund with the best performance over the previous six months and kept switching every six months into the new best performer, they would have outperformed the market by a vast margin. Over that time the FTSE 100 has gained around 250% (6.5% per year), including dividends, while a Bonkers portfolio would have returned 3,080% (almost 19% per year).

Obviously, no prudent investor would have followed this strategy, because it involves concentrating their wealth in a single high-flying fund. Doing so would have been far more volatile than the
wider market: annualised volatility would have been 23%, compared to 14% for the FTSE 100. More importantly, it would be very exposed to the possibility of sudden, devastating losses, since it would often be invested in bubbly sectors, aiming to get out before the bubble bursts.

With this kind of approach, there’s always a risk that the downturn comes too quickly and an investor would see a large amount of their wealth wiped out before they rotate into a new fund (for example, earlier this year, China’s CSI 300 index fell by 30% in just 17 days). Just because this didn’t happen to any of the funds during the period over which the portfolio was backtested doesn’t mean it’s impossible.

But there are still some interesting lessons for investors. The portfolio isn’t a magic formula: it’s simply an example of the momentum effect. Momentum refers to the tendency for securities that have been rising strongly to keep rising and is one of a handful of well-documented market anomalies, alongside others, such as the value effect (the tendency for stocks that are lowly valued on metrics such as the price-to-book ratio to outperform).

It’s an extreme example, but you can find equally dramatic results elsewhere. Value-orientated strategies of investing in emerging markets with the highest dividend yields or with the weakest currencies would have theoretically returned an average of more 30% per year from 1976 to 2013, according to Elroy Dimson, Paul Marsh and Mike Staunton in the Credit Suisse Global Investment Returns Yearbook.

While you wouldn’t want to emulate the Bonkers portfolio or stick everything into distressed emerging markets, it’s possible to employ these anomalies in more measured ways. For example, the MSCI World Momentum index (which essentially tracks the 30% of stocks in the MSCI World with the strongest price momentum) has returned almost 10% per year over the same period in sterling terms over the past 20 years. The question is whether this outperformance will continue. Research suggests that the momentum effect has persisted over time and across different markets.

However, all these anomalies go through periods when they work and periods when they underperform. The last 20 years has been good for momentum, helped by three strong bull markets. It’s been bad for value, which has only very modestly beaten the wider market – but value has tended to do better in difficult markets. Since it’s impossible to predict which is likely to do best in future, one approach is to build a portfolio around multiple factors, such as momentum and value. History suggests that this is likely to beat the overall market over time. Exchange-traded funds (ETFs) such as the iShares MSCI World Momentum Factor ETF (LSE: IWFM) and the iShares MSCI World Value Factor ETF (LSE: IWFV) make this increasingly easy to do.

Factor investing – the strategies that do best

Factor investing — meaning strategies that involve picking securities based on metrics such as momentum and value — is one of the hottest areas in investment at present. Researchers are trotting out an endless stream of papers on new factors that seem to be associated with outperformance. Very few of these are likely to be persistent market effects that can be usefully exploited to earn better returns. Indeed, a study in 2014 by Cam Harvey, Yan Liu and Heqing Zhu that reviewed 315 different factors concluded only a handful are likely to be meaningful.

So which factors are established? The value effect is well documented and appears to have worked in most markets around the world. The usual metric for identifying value stocks is the price-to-book ratio (meaning the firm’s share price divided by the value of its assets minus its liabilities), although other metrics, such as dividend yield, are used by some analysts.

Likewise, momentum appears to be robust. The well-known small-cap effect — the tendency for smaller stocks to outperform larger ones — is more contentious. Studies suggest that it has not worked in all markets; where it has worked, it may be due to exceptional returns from a few outliers rather than smaller companies in general.

More recently, a great deal of attention has focused on low volatility investing — the apparent outperformance of stocks whose share price is less volatile than average. Theoretically, this shouldn’t happen — more volatile stocks should deliver higher returns to compensate investors for the added risk. But most research suggests the effect is real and applies in markets around the world.