By Alex Bryan
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 U.S. 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 U.S. Real Estate (NYSEARCA:IYR), iShares U.S. Financials (NYSEARCA:IYF), and iShares U.S. Energy (NYSEARCA: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.
Investors could apply a similar strategy using single-country index funds in their foreign equity allocations. For this analysis, I included the MSCI country indexes for all members of the developed-markets MSCI World ex USA Index with a December 1969 inception date. This left 17 country indexes. Each year from December 1974 through 2013, I ranked these indexes by their returns over the previous five years and selected the five with the worst returns. I employed the same weighting and rebalancing approach as that described for the sector strategy. As before, I repeated this analysis using four-, three-, two-, and one-year return ranking periods.
The portfolios of country indexes with the worst returns over the previous four to five years offered notable return improvements over the MSCI World ex USA Index. They were also more volatile, but still managed to generate better risk-adjusted performance. Unlike the contrarian sector strategy, the portfolios formed on shorter-term return rankings kept pace with the benchmark, though they exhibited greater volatility. However, they did underperform when I increased the rebalancing frequency to monthly or quarterly, which suggests that poor performance tended to persist in the short term. Contrarian investing requires patience. Depressed assets may become cheaper in the short run and it can take a long time for them to rebound.
At the end of last year, the five-year contrarian strategy held the MSCI Austria, France, Italy, Japan, and Spain indexes. Investors can gain similar exposure through iShares MSCI Austria Capped (NYSEARCA:EWO), iShares MSCI France (NYSEARCA:EWQ), iShares MSCI Italy Capped (NYSEARCA:EWI), iShares MSCI Japan (NYSEARCA:EWJ), and iShares MSCI Spain Capped (NYSEARCA:EWP). Italy, Spain, and France are still scary places to invest. They have been struggling with anemic economic growth over the past few years and, while conditions have improved, they are not out of the woods yet. However, investors' fear can depress valuations and create more attractive return opportunities going forward. Only Japan and Austria look especially cheap relative to the group based on price/forward earnings ratios. But all five country indexes fall in the cheapest half of the selection universe based on price/book ratios, and Japan, Austria, and Italy are the cheapest three.
Asset Class Strategy
Tough though it may be, buying asset classes that have been unloved for few years also appears to be a winning strategy. For this analysis, I included the 10 indexes in the table below in the asset class strategy.
I followed the same procedure as described for the previous two strategies. However, this strategy targeted the three indexes with the worst prior-period returns. I ran the portfolio simulation from the end of 1995 (the earliest point at which five years of data became available for all the indexes) through 2013.
It is difficult to select an appropriate benchmark for an asset class strategy. For the purposes of this study, I included both the Vanguard Balanced Index (VBINX), which maintains a passive 60/40 allocation to U.S. stocks and bonds, and an equally weighted portfolio of all 10 eligible indexes. The portfolios of indexes with the worst returns over the previous three to five years offered better absolute and risk-adjusted returns than both the equally weighted and Vanguard Balanced benchmarks. Similar to the sector strategy, those with the worst returns over the previous one to two years continued to underperform the benchmarks.
At of the end of 2013, the contrarian asset class strategy based on the previous five-year returns was invested in the Dow Jones UBS Commodity, Barclays U.S. Aggregate Bond, and Barclays Global Treasury ex U.S. indexes. Investors can gain access to the Dow Jones UBS Commodity index through iPath DJ-UBS Commodity Index (NYSEARCA:DJP). However, bond valuations conflict with the contrarian buy signal. Bonds have underperformed because interest rates have been depressed over the past few years. Yield-to-maturity is an upper bound on the returns investors can expect from bonds over the long term. The current yield-to-maturity on iShares Core U.S. Aggregate Bond (NYSEARCA:AGG), which tracks the Barclays Aggregate Bond Index, is currently only about 2.1%. The yield-to-maturity on SPDR Barclays International Treasury Bond (NYSEARCA:BWX), which tracks a capped version of the Barclays Global Treasury ex U.S. index, is even lower (1.8%). If interest rates start to rise, these funds' short-term returns could be worse.
- Betting on assets with poor recent performance is a bad idea. In the short term, momentum dominates, which means that recent laggards often continue to disappoint and recent leaders remain aloft.
- However, assets that underperform over longer periods (four to five years) eventually become cheap and poised to offer better returns.
- Investors can take advantage of these long-term reversals with a contrarian strategy using ETFs. This strategy may work better when investors consider valuations together with the contrarian signals.
De Bondt, Werner and Thaler, Richard. "Does the Stock Market Overreact?" The Journal of Finance, Vol. 40, No. 3, 1985.
Jehadeesh, Narasimhan and Titman, Sheridan. "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency." The Journal of Finance, Vol. 48, No. 1, 1993.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.