I confess to drastically overstating the case to get your attention. But Andrew Haldane is an economist at the Bank of England. He recently gave a speech on Patience and Finance, which was commented on by Gavyn Davies in the Financial Times. Mr. Haldane made some comments about the puzzling success of trend following strategies versus using value, summarized by Mr. Davies:
Andy Haldane conducts the following experiment. He estimates the results of an investment strategy in US equities which is based entirely on the past direction of the stockmarket. If the market rises in the period just ended, the strategy buys stocks for the next period, and vice versa. In other words, the strategy simply extrapolates the recent trend in the market. The result? According to Andy, if you had been wise enough to start this procedure with $1 in 1880, you would have consistently shifted in and out of stocks at the right times, and you would now possess over $50,000. Not bad for a strategy which could have been designed in a kindergarten.
Next, Andy tries an alternative strategy based on value. This calculates whether the stockmarket is fundamentally over or undervalued, and buys the market only when value gives a positive signal. The criterion for measuring value is the dividend discount model, first devised by Robert Shiller. If you had been clever enough to devise this measure of value investing in 1880, and had invested $1 at the time, the procedure would have left you with a portfolio now worth the princely sum of 11 cents.
I am sure that fundamentalists will argue that this particular value strategy is far too simple, and that other ways of using the Shiller p/e or alternative measures of value would produce much better results. That may be the case, but it does not detract from the fact that a very basic momentum-based technique seems to work very well indeed. And that should not be true if you believe in the efficiency of capital markets.
I’m not too surprised by the good performance of the trend following strategy (but I am shocked by the terrible, terrible performance of the dividend discount model). Clearly, there is some universal characteristic that is being captured in the momentum factor. Maybe it is something psychological like investor confidence, or perhaps it is closely related to the underlying fundamentals and the business cycle.
As Mr. Davies points out, this observation is very problematic for efficient markets and Modern Portfolio Theory. The whole rise of passive investing-using index funds and giving up on picking stocks-is based on the assumption that markets are efficient. I see this indexing approach extolled for individual investors all the time now. However, if markets are not efficient, for whatever reason, passive investing is bunk.
I have to come down on the bunk side of the ledger. The momentum anomaly is far too well-established for claims that passive investing is the only thing that makes sense. Whatever the underlying process is, it has worked since 1880-and continues to work today. (Some of our published research shows that models written about almost 40 years ago still generate a similar level of excess return in today’s markets, so it’s not simply a case of the anomaly being unknown.)
Instead, why not act to take advantage of relative strength as a return factor? Maybe trend following powered by relative strength is finally coming into its own.
