Benchmark portfolios: risks that pay, risks that don’t

  • Defensive stocks have had a bad start to the year, but they are doing well on average over the long term.
  • Some risks (such as those related to value and high beta stocks) are not profitable, even in the long run.

So far, 2022 has been a bad year for almost all stock pickers. Only 21 of 244 funds in the unit trust sector for all Trustnet businesses beat the Scottish Widows All-Share tracker – and most of these were FTSE 100 trackers.

There is a simple reason for this. Stock indices, and therefore tracker portfolios, are weighted by market capitalization, so Shell, with a market capitalization of £160 billion, has nearly 35 times the weighting of the largest FTSE 250 stock (Unite ). Which means that if a few big stocks outperform the small ones, the All-Share Index will outperform most stocks, with the result that most stock pickers will underperform.

And that’s exactly what happened. So far this year, Shell is up 24.2% while the FTSE 250 has fallen 10.9%. Other large commodities stocks also performed well. In fact, the Big Five (Shell, BP, Anglo American, Rio Tinto and Glencore) have risen an average of 25% so far this year, adding 3.6 percentage points to the All-Inclusive Index. Share. Without their performance, the index would be down 5.1% so far this year rather than down 1.5%.

Whether you beat the market this year is therefore to a large extent simply a matter of your position in the big commodity stocks. If you were overweight at the start of the year, you probably beat the market. And if you were underweight, you probably underperformed. And most active fund managers were underweight.

Against this backdrop, it should come as no surprise that my thoughtless model portfolios have underperformed so far this year.

What is surprising, however, especially in light of the overall market downturn, is the poor performance of my low-risk portfolio. It fell 15.6% in the first quarter. Its alpha (that part of returns that cannot be explained by its covariance with the market) has been worse recently than at any time since I started the portfolio in 2005.

Reckless portfolio performance
at Q1 last 12 months last 3 years last 5 years last 10 years
Momentum -6.7 -3.2 45.1 48.2 195.4
Negative momentum -20.0 -22.5 -3.2 -9.0 -40.5
Assess -5.9 -9.2 -25.8 -39.7 8.1
High beta -2.5 -21.8 -20.9 -26.8 -23.2
Low risk -15.6 -13.9 15.5 0.4 52.2
Mega caps 8.4 17.8 2.9 4.6 27.4
FTSE350 -0.3 9.5 4.6 3.8 37.4
Price performance only: excluding dividends and transaction costs

To a large extent, this was due to the collapse in prices of Russian-exposed stocks such as Eurasia Mining, Polymetal and Petropavlovsk (although Just Eat and Pets at Home also performed poorly). Of course, these actions were risky: doing business in Russia always has been. But these risks were largely independent of the general risk of the UK market, so these stocks had low betas and therefore entered my portfolio.

Which tells us that it is difficult to identify low-risk stocks. Stocks that have had low betas in the past may well not retain those low betas. In this sense, “defensive” actions are a misnomer: they are risky.

But, on average, we get paid well for taking those risks. Over the past 10 years, my low beta portfolio has beaten the market. It’s not an idiosyncratic quirk of my particular portfolio. Robeco Quantitative Investments economists have shown that, over the long term, less volatile stocks fare better than they should on all major stock markets. On average, it is therefore better to be on the defensive.

The inverse of my defensive portfolio is my high beta portfolio. The latter held up well in the first quarter, thanks to strong increases in Harbor Energy and Kosmos Energy. This relatively good performance is not typical, however. Over the past 10 years, my high beta portfolio has significantly underperformed the market. Again, it’s not weird. It corroborates the work of economists at AQR Capital Management showing that it pays to bet against the beta.

One strategy has done even worse than defensives so far this year: negative momentum. My portfolio of the 20 biggest losers of the last year fell 20% in the first quarter. We cannot attribute this solely to a Russian effect: THG, Just Eat, Asos and Aston Martin Lagonda all experienced bad quarters of an hour.

Here, however, there is a huge difference with my defensive portfolio. While the latter has done well over the long term, the negative momentum has not, except for a big jump at the end of 2020 when the discovery of a Covid vaccine boosted former losers such as Carnival and Cineworld. It has underperformed the market by nearly 80 percentage points over the past 10 years. In risk-return terms, this makes little sense. Shares that have fallen significantly are riskier than average: they record losses or their business model is called into question. And, in theory, higher risk should mean better average returns. That it didn’t happen suggests that something else is going on. This something is probably an under-reaction. Investors don’t react enough to stocks that receive bad news, but cling too tightly to their prior belief that they are good stocks and hold onto them in hopes of breaking even. Such underreaction means that former losers are on average overvalued and therefore offer mediocre returns.

The flip side of former losers hurting is that former winners should do well. In the first quarter, however, this was not the case. My dynamic portfolio lost 6.7% due to the decline in Future. Greggs and Impax, among others, offset strong gains in Serica Energy and Pantheon Resources.

Over the long term, however, my dynamic portfolio has done surprisingly well. Which, again, is not a simple oddity. Research shows that momentum investing works in the United States, international markets, commodities, and forex markets. My wallet is just one more piece of evidence. But it is important. Over the past 10 years, it has beaten all but eight funds in Trustnet’s all-company sector. A simple policy of buying stocks that rose beat almost every other strategy. This suggests that reflection does not add much value to the investment process.

In part, the excellent performance of momentum is a reward for risk taking: momentum stocks sometimes underperform falling markets, as we saw at the start of the pandemic. But that’s unlikely to be the whole story. Momentum is also doing well simply because investors are underreacting to good news.

Another strategy for having a bad quarter was value investing. My portfolio of top 20 producers fell, thanks to declines in Evraz, Ferrexpo and Polymetal offsetting rises in Rio Tinto, BHP and BAT.

This continues a long tendency for value stocks to perform poorly despite being riskier than others: high yield is often a sign of additional risk, often in the form of recession exposure. This may be because a world of slow growth – which we have known for the past decade – is one in which the advantage of taking cyclical risks rarely materializes. Whatever the reason, we have yet another risk that doesn’t pay off.

Which brings us to the general point. Textbook economics and common sense tell us that higher risk should mean greater reward in the long run: you have to speculate to accumulate. But this is not true. Many risks such as former losers, value stocks and high beta stocks do not pay off on average. But other risks such as dynamic or defensive stocks do.

We can explain that. Investors underreact to good and bad news, underestimate the virtues of lackluster stocks, and chase the small chance of big gains. But that only leads us to a conundrum. In principle, investors should already be aware of these errors and therefore have eliminated them. Perhaps the recent poor performance of defenses and momentum is a sign that they have. But whenever I’ve suspected this in the past, I’ve been wrong. Will I be again? We can only know by monitoring these strategies.

The new thoughtless wallets.

Momentum (best performers in last 12 months): Alpha FX, Brewin Dolphin, Clipper Logistics, Drax, EnQuest, Glencore, Indivior, Investec, John Menzies, Kosmos Energy, Meggitt, MP Evans, Next Fifteen, Safestore, Serica Energy, Shell, SolGold, South32, Ultra Electronics, Swiss Watches.

Negative momentum (worst performers in past 12 months): 888, Asos, Aston Martin, Boohoo, CMC Markets, Countryside Partnerships, Deliveroo, Dr Martens, Ferrexpo, Flutter, Frontier Developments, JD Wetherspoon, Just Eat, Moonpig, Ocado, Polymetal , PureTech, S4 Capital, THG, Trainline.

Assess (highest dividend producers): Abrn, Ashmore, Atalaya Mining, BHP, Centamin, CMC Markets, Direct Line, Diversified Energy, Ferrexpo, Genel Energy, Gulf Keystone, Imperial Brands, Jupiter, M&G, Persimmon, Phoenix, Polymetal , Rio Tinto , Seplat, Synthomer.

High beta: Asos, Carnival, Crest Nicholson, easyJet, Elementis, EnQuest, FirstGroup, Gulf Keystone, Hammerson, Harbor Energy, International Consolidated Airlines, IWG, Jet2, John Menzies, Kosmos Energy, Micro Focus, SIG, Stagecoach, Tullow, Vistry.

low beta: Assura, CMC Markets, Diversified Energy, Fresnillo, Hikma, Hipgnosis, Indivior, JTC, Kainos, National Grid, Pennon, Pets at Home, Plus 500, Polymetal, Primary Health, PZ Cussons, Reckitt Benckiser, Smart Metering Systems, Unilever, YouGov.

Mega caps: Anglo American, AstraZeneca, BAT, BHP, BP, Compass, Diageo, Experian, GlaxoSmithKline, Glencore, HSBC, Lloyds Banking, London Stock Exchange, National Grid, Prudential, Reckitt Benckiser, RelX, Rio Tinto, Shell, Unilever.

All portfolios are equally weighted baskets of 20 non-investment fund stocks with a market capitalization of over £500m.


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