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NEW - research from London Business School

Posted by: Brian Dennehy
London Business School, and Elroy Dimson in particular, have for many years been a great source of very detailed research on momentum investing, and much more besides.  Their latest insights* are more intriguing than ever.
Many of you might have read about “smart beta” or “factor investing”, particularly in the last 12 months when it has become very faddish.  “Factors” are derived from academic research, specifically the “factors” or characteristics which appear to give patterns of returns which are likely to generate better-than-average or better-than-index returns.
Apparently at least 316 such factors have been identified, though nearly all are “unlikely to be robust”**. [This does beg the question why three-quarters of the world’s biggest investors, responsible for $2 trillion+, are following such strategies.  I refer learned readers to the chapter of my book “Big Brains, No Common” (extract here).  But I digress…]
Elroy Dimson fairly gives credit to himself for highlighting the (probably) only five factors that do work consistently and repeatedly, way back in 1988 in his “Stock Market Anomalies”.  We have also regularly highlighted these anomalies in blogs (e.g. “Only 4 ways to beat the market” – we have one less than Elroy as it cannot be easily exploited by retail investors).
In this latest research Elroy and his team again focus on the “factors” where there is evidence of long term success. They updated the numbers for the US and UK, from 1926 and 1900 respectively, and extended the analysis to another 23 countries over 43 years. The numbers are striking. 
For example, a simple formula for the UK (buy the top 10 performing FTSE 100 stocks, and review every 6 months) generated an extra 3.91% of growth per annum versus the index.  Our own numbers from 1994 (selecting the top 3 UK growth funds every 6 months) are even more compelling – an extra 5.88% per annum of growth i.e. the index went up 449%, and our Dynamic UK Portfolio soared 1,632% - see results sector by sector here.
They also highlight (again) that a 6 month look-back and review period works best, as confirmed by our own extensive research focussed on funds.
Their extended analysis showed that momentum also worked well in 21 out of those 23 countries, leading them to comment that:
“momentum trading has generated a disturbingly large abnormal return”
It would be particularly disturbing if you missed out!
It is, as Elroy calls it, a “naïve strategy”, but it persistently repeats in a way which is almost insulting to those who have made it their life’s work to explore the depths of markets and look for a Holy Grail – that was me, for many years exploring those depths, but no longer.
Even Eugene Fama (a world expert on markets, who has also been called the High Priest of the Efficient Market Hypothesis) describes momentum as the “premier anomaly” – high praise indeed from the man who would have you believe you should just buy and hold passives.
Elroy goes on to say:
“the state of theory in this area is rudimentary and exploratory… 
[there is] no satisfactory explanation for expecting a premium from the momentum factor”
I love that. The team at London Business School are world class mathematicians. As frustrating as this might be for the LBS team, you can measure the outcome of momentum, but you cannot explain why it works with an equation. That is because it is a behavioural phenomenon, not the behaviour of one person, but that of many investors spread around the globe.
Momentum arises because the herd of investors is buying. But the herd members are not uniform, do not all decide to join the herd of buyers at the same time, are driven by a variety of priorities, have a wide range of personal peculiarities (biases) weighing on their decision making, and eventually buy for a foggy miscellany of reasons which cannot be captured in a useful mathematical formula.
As an aside it is interesting to reflect on the 5-wave shape of upward trends in stock markets, which I have been observing (and exploiting) for more than 30 years (Trying to know the unknowable). Though the behaviour of individual investors might not be usefully or easily fathomable, it is fascinating that the herd of buyers often grows in a pattern which frequently repeats.
Putting that to one side for now (a rabbit hole for another occasion!) I leave you by repeating Elroy’s comment:
“momentum trading has generated a disturbingly large abnormal return”
Do keep your feedback and questions coming, and thank you for reading.
* “Credit Suisse Global Investment Returns Yearbook 2018”, Dimson, Marsh, Staunton.
** “…And the cross-section of expected returns”, Harvey, Liu and Zhu (2016)
Topic: Investment research


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