Performance tends to persist in the short run, but betting on long-term losers can be a winning strategy.
I have always admired contrarians. It isn't easy to think and act independently. Clients evaluate professional managers' performance against a benchmark, often over short windows. Those who underperform for a few years risk losing their clients, even if their investments ultimately pay off. That makes it difficult for many managers to make bold bets. Investing mistakes may also be easier to swallow when everyone is in the same boat. There is comfort in conformity, but this innate social desire can create opportunities for those who have the courage to think independently.
Fear and greed may create herding behavior. Investors tend to chase performance, buying securities that have recently done well and selling those with poor performance. This may partially explain the short-term persistence in asset returns, known as momentum. Generally, assets that have outperformed over the past six to 12 months continue to outperform over the next several months, while those that have underperformed continue to do so. That might suggest that a contrarian strategy wouldn't work well. Indeed, trading against momentum has historically been a losing strategy.
Yet, short-term momentum may push asset prices away from their fair values, leading to long-term reversals in asset returns, which is associated with the value effect. Assets with poor returns over long horizons eventually become cheap, and as a result, may offer better returns going forward. In a study published in 1985, De Bondt and Thaler found that stocks with the worst returns over the previous three to five years outperformed those with the best prior returns over the next three to five years. (However, a disproportionate portion of this outperformance occurred in January.) While this is a fairly crude approach to value investing, it illustrates that investors should fight the urge to extrapolate past performance into the future. Often, assets with dismal past performance offer the best opportunities. (Our own Russ Kinnel's “Buy the Unloved” series describes a contrarian fund strategy that attempts to take advantage of this effect.)
Even if asset returns mean revert on average over the long term, many individual securities will not due to changes in the competitive landscape that may permanently impair a company's fundamentals (think BlackBerry). Investors could more effectively diversify this type of company-specific risk by applying a contrarian strategy using exchange-traded funds, which each hold many securities. To illustrate, I ran an analysis of contrarian strategies with sector, country, and asset class indexes, rather than individual securities. Investors can gain access to each of these indexes through ETFs.
It's no secret that sectors fall in and out of favor. To test whether investors could profit from systematically buying the most beaten-down sectors, I studied the 10 Dow Jones U.S. sector indexes. IShares' U.S. equity sector ETFs track these indexes, but investors can get similar exposure through Vanguard and SPDR sector ETFs. Once a year, I ranked the indexes by their returns over the previous five years and selected the three with the worst returns. Initially, these holdings were equally weighted, but they were not rebalanced until they were removed from the portfolio. For instance, if two positions were sold, the proceeds would be divided equally between the two new holdings. However, the existing holding would remain in the portfolio at its current weighting. This approach reduces turnover and makes the strategy easier and less costly to implement. I started the portfolio simulation in December 1996 (using index return data starting in December 1991, the earliest available) and ran it through 2013. I repeated this analysis using the return rankings over the previous four-, three-, two-, and one-year periods. The table below illustrates the results.
Consistent with De Bondt and Thaler's findings, a strategy that targets the sector indexes with the worst returns over the previous four- and five-year periods offered better absolute and risk-adjusted performance than the broad market-cap-weighted Dow Jones US Index. However, the portfolio that targeted the sectors with the worst trailing three-year returns did not outperform. As the table above illustrates, the shorter ranking periods tended to have worse performance. These findings are consistent with negative short-term momentum and long-term reversals. Buying assets with poor short-term performance is like trying to catch a falling knife--it's probably going to hurt. But performance tends to mean revert in the long run. Therefore, a strategy of buying assets with a long stream of poor performance has a greater chance of success.
At the end of 2013, the contrarian strategy based on previous five-year returns held the financial, oil & gas, and real estate sector indexes. Investors can get exposure to these indexes through iShares US Real Estate IYR, iShares US Financials IYF, and iShares US Energy IYE. Before pursuing a contrarian strategy, it is good practice to make sure that the valuations jibe with contrarian signal. They are often consistent, but not always. In this case, the financial and energy sectors are currently the cheapest of the 10 indexes based on price/forward earnings and price/book. In contrast, the real estate index trades at the highest multiple of forward earnings, though its price/book valuation is more reasonable. It is currently the fourth-cheapest sector on that metric.