Is a less intensive momentum strategy a workable alternative for long-term investors? Cherry Reynard discusses the options.
Those who invest in stock markets are well-versed in the highs and lows they entail. However, there is always a dilemma over how long to wait for an apparently weak fund manager to come good. Have they lost their edge permanently? Or are they simply going through a bad patch? The travails of a certain high-profile fund manager in recent months illustrate the quandary for investors.
Momentum strategies do away with this problem. They target the managers who have been impressive in recent months, hoping they will continue to be so for some time to come and that when they start to decline the system will issue an alert.
This approach is not very fashionable: the received wisdom is that it's all about the long term and proper diversification, and that past performance counts for little. Be patient enough and allow managers time to demonstrate their skill: these are the mantras of the investment management industry. But the recent problems at Woodford Investment Management call this into question.
For Douglas Chadwick, architect of the Saltydog investment strategy, Woodford's troubles are a vindication of his approach. He says:
"Surely this is another nail in the coffin for a blind ‘buy and hold' philosophy and three cheers for an active informed momentum approach to your portfolio?"
To some extent, Chadwick's momentum-based approach holds the investment management industry to account, forcing it to examine some of its most firmly held beliefs – buy and hold, low trading costs, that past performance is no guide to the future.
It works on the principle that strong performance persists for some time, and that by finding sector trends and backing them investors can make more money. Chadwick says these trends usually have a life-span of three to six months. Momentum investing suggests that markets work on emotion, rather than efficiency. Investors tend to herd together, so trends can be persistent.
He devised the Saltydog momentum strategy in 2000, looking at performance of all the funds within the Investment Association (IA) sectors over four weeks, 12 weeks and 26 weeks:
"We made it so that people could see which fund managers were working well in every sector."
Investors can choose those funds working well in each sector – he has devised a loose risk categorisation. At the top is 'full steam ahead' (emerging markets, China) and at the bottom is 'money markets'. He aims to present the figures in an easy-to-understand way, so that investors can follow the top performers and adjust their own portfolios.
Tweaked along the way
Since devising the process, he has tweaked it along the way, bringing in volatility scores, for example, which knock out top-performing but highly volatile funds. He has increased the performance hurdle to focus on top-decile funds, and has also sought to knock out those funds that dip below the fifth decile more than four times.
Saltydog runs two main model portfolios – the Tugboat and the Ocean Liner (Chadwick also did a spell in the merchant navy, hence the nautical references). The Tugboat aims for an annual return of 5%, but without the drops. The Ocean Liner is designed to be more ambitious.
Tugboat was launched towards the end of November 2010 and is currently showing a gain of 62.3%, beating what Chadwick views as the most relevant sector, the IA mixed investment 0-35% shares sector, which over the period returned 44.6%. Ocean Liner set sail three years later, in November 2013, and has produced gains of 37.3%, ahead of, again, what Chadwick considers the fairest sector to pit performance against, IA mixed investment 20-60% shares, with the average fund in that sector returning 31.6%.
However, the approach has become more difficult given the currently volatility created by the macroeconomic environment. Trump tweets can be distracting and can throw out short-term numbers. Equally, his system is intensive, involving weekly updates from Saltydog and trading adjustments. This is likely to push up trading costs, though the total will depend on the platform used.
Buy and fall asleep
For those with less time on their hands, Chadwick has now devised an approach that requires a little less work and misses some of the volatility. It involves isolating those funds that have produced a 5% gain over every six-month period during the last three years, so six periods in all; Chadwick describes it as a cross between ‘buy and hold' and a Saltydog frequent switching investing approach.
The regular 5% target is an ambitious one and only six funds out of the whole open-ended fund universe have achieved it: Neptune Global Technology, GAM Star Technology, Baillie Gifford American, Baillie Gifford Global Discovery, Lindsell Train Global Equity and AXA Framlington American Growth. A further 30 or so hit it five out of six times. The six winning funds are unsurprisingly, to be found in the IA technology, North America and global sectors (two in each). The performance of these funds has been astonishing, as our accompanying table shows.
Funds that hit the Saltydog mark
|Fund||3m (%)||6m (%)||1yr (%)||3yr (%)|
|AXA Framlington American Growth||11||30.1||20.8||77.8|
|Baillie Gifford American||11||33||17.1||113|
|Baillie Gifford Global Discovery||5.6||29||12.4||95.5|
|GAM Star Technology||7.6||24.2||11.5||102.8|
|Lindsell Train Global Equity||11.8||24.9||22.9||83.3|
|Neptune Global Technology||8.6||26.2||20.2||117.2|
Source: FE Trustnet. Data to 4 July 2019.
The next layer down – those funds that have achieved 5% return in five out of six periods – are also heavily dominated by technology and the Polar Capital Technology (LSE:PCT) appears, as does AXA Framlington Global Technology, Fidelity Global Technology and L&G Global Technology.
Fifteen of these 30 high-achieving funds are in the North American sector. For investors schooled in the investment wisdom of diversification, this runs counter to received wisdom. That said, investors could apply the same technique to individual sectors.
Also, because technology has dominated, it means there have been strong returns to be made simply from picking up on that trend and running with it. According to research from Jim Paulsen, chief investment strategist with the Leuthold Group, the rolling one-year correlation between the performance of the S&P 500 technology sector index and the MSCI USA Momentum Price index recently rose to its highest level since late 2000 (the momentum index tracks large- and mid-cap stocks with high price momentum).
Tech stocks make up about 26% of the S&P 500 index's market capitalisation, but over the past year have accounted for almost 43% of the top 100 stock performers based on market capitalisation.
What does this mean for the strategy? Certainly, it means that the magnitude of returns seen to date may not be available in the longer term. However, it shouldn't mean that the system goes wrong, just that it finds its returns elsewhere.
"As one sector drops away, another one will come along, and if it doesn't, we move towards cash. There have been three major drops since 2008 and at each time when there's nothing there that's going up, the algorithm pushes you towards cash."
Problems may come, however, if markets move very quickly. The system only rebalances every three months and, as the sell-off in the final few months of 2018 proved, highly rated technology stocks can sell off rapidly and savagely in short periods of time. On the other hand, they are now back at a similar level to six months ago, near their all-time highs, so these short-term falls may not matter particularly in the longer term.
Importantly, Chadwick has no agenda. He hasn't built a career on being a value or growth investor and doesn't therefore need to make a spirited defence of either approach. Saltydog is unusual and brings something different to a portfolio. It may make an interesting ballast to a value approach, ensuring that investors are picking up on trends while waiting for the market to turn.
Alternative options for momentum hunters
Brian Dennehy, of FundExpert.co.uk, uses a similar investment philosophy, investing in funds with top performance over the previous six months. His research suggests they will maintain performance for about a year, but investors need to be ready to switch out as soon as performance starts dropping. He conducts a full review of his holdings every six months.
From the start of 2019 to the end of June, the best performing fund has, oddly, been the passively managed Pictet Russia Index fund, up 32.2%, followed by Brown Advisory US Smaller Companies and Brown Advisory US Mid-Cap Growth, both showing a return of 31.3%.
Rather than blindly pick the best performers that have wind in their sails, another approach would be to consider fund managers that have a momentum-driven strategy at the heart of their investment process. One such example is Money Observer Rated Fund Merian North American Equity, managed by Ian Heslop.
Momentum ETFs are another option: they target shares displaying the strongest momentum characteristics in its investment universe. These are passive strategies, but rather than companies being weighted according to their size, as happens in a normal index such as the FTSE 100, they are weighted according to momentum characteristics.
The Vanguard Global Momentum Factor UCITS ETF, for example, uses scores based on 11-month momentum, six-month momentum and risk-adjusted 1-year momentum. These ETFs usually form part of a company's ‘factor range'. Others include the iShares Edge MSCI Intl Momentum Factor ETF and the Invesco DWA Momentum ETF.
Top funds in first half of 2019
|Fund||6-mth total return (%)|
|Pictet Russia Index||32.15|
|Brown Advisory US Smaller Companies||31.31|
|Brown Advisory US Mid-Cap Growth||31.28|
|Aubrey Global Conviction||30.37|
|LF Ruffer Gold||29.42|
|Threadneedle Pan European Focus||29.41|
|TM Cavendish AIM||29.40|
|Robeco Global FinTech Equities||29.33|
|Aberdeen Eastern European Equity||29.29|
|Legg Mason IF Martin Currie European Unconstrained||29.24|
Source: Willis Owen. Data to the end of June 2019.
Past performance is not a guide to future performance
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