What does this show?
The chart shows how small-cap investors would have done last year by following one of five popular styles of investing. The stocks in the data belong to the Numis Smaller Companies Index, which incorporates all shares making up the bottom 10 per cent of the UK equity market. It is larger by value than the FTSE SmallCap index, which takes just under the bottom 4 per cent of the index, but smaller than the FTSE 250, which takes around 15 per cent of the market by value.
Overall for 2016, small-cap stocks did worse than their large-cap cousins, reversing the 2015 trend of the minnows outperforming. Part of the reversal was down to the “Brexit effect” — as sterling weakened in the aftermath of the vote to leave the EU, investors moved into the blue-chip index in a bid to limit their domestic exposure. Large-cap companies were estimated to have made about 70 per cent of earnings overseas, according to JPMorgan, while the FTSE 250 had around half.
What do all of these styles mean?
Investors have always found ways to pick stocks beyond just following an index, and most fund managers have a particular style. Income investors choose stocks yielding income and value investors choose stocks with low share prices. According to Numis, the broker, when it comes to small-cap companies, investors did best with these two styles of investing.
Investors choosing “low-risk” stocks with not much share price movement or volatility, meanwhile, had a terrible 2016 following a run of successful years. Momentum investors — who bet that stocks with rising prices will continue to see their prices rise, while losing stocks will continue to lose — also did poorly. Paul Marsh, a professor at London Business School, says the momentum strategy relies on “the trend being your friend”, which is not always the case.
Size, in this chart, is a measure of how much better smaller stocks have done than larger stocks.
Why have momentum and low-risk investors done so poorly?
As an investment strategy, momentum does badly when market trends reverse sharply, something which happened at least twice last year, says Prof Marsh. There was a downturn in all equity markets at the start of the year, which then went into reverse. The Brexit vote came in June, and was then followed by a recovery. Mining stocks also bucked their run of being the losers to become the best-performing shares of 2016. “All of this is very bad for momentum investors,” says Prof Marsh.
As for a “low volatility” strategy, it is “theoretically” expected to deliver low returns as investors take less risk, but this has not been the case until this year. “It’s been puzzling because [this strategy] was doing much better than the market, which you don’t expect,” says Philippe Ferreira, global strategist at Lyxor, the asset manager.
There are lots of theories about why investors looking for stable stocks have done badly in 2016. Investors trying to avoid volatility would not have invested in oil, gas and mining stocks — and would have then missed out on their big recovery in 2016, says Prof Marsh.
Mr Ferreira says that the rise and fall of “bond proxy” stocks have also played a part. Bond proxies — equities which provide stable income streams — are often included in portfolios built around low volatility. These stocks have been very popular while bond yields have been depressed, but less popular as yields have risen in recent months.
Is this just a small-cap trend?
No — the trends broadly hold for larger stocks too.
So what stock selection strategies should I be using in 2017?
Mr Ferreira predicts another year of surprises. “It pays to be diversified,” he says. “We’ve seen value biased managers performing very poorly in three or four years outperforming in 2016 and we’ve seen managers geared towards defensive stocks who did well in the past doing badly now,” he says.
Sample the FT’s top stories for a week
You select the topic, we deliver the news.