The biggest question in investment - I think I’ve found the answer

With equity markets hitting new highs this year, and new records for both bitcoin and gold, investors are faced with a difficult choice. Do they stick with the winners? Or do they go in search of more out-of-favour investments that they hope might pick up the baton, or protect their gains if the market corrects? Momentum investing, in other words, or a more defensive, contrarian approach?

To try and answer these questions, I spent a few hours diving into the performance data for the funds on our Select 50 list of favourite funds. I restricted my research in this way to try and match the experience of an engaged but non-professional investor with limited time and resource. It’s hard enough to put together a portfolio from a curated shortlist of funds such as ours, and it’s a better reflection of how most self-directed investors will go about things.

My starting point was March 2020, when global markets were finding their feet after the shock of Covid. It’s arbitrary, but enough has happened since then to even out regional differences and the impacts of changing investment styles. The period includes a recession, an inflationary spike and a complete monetary tightening cycle.

Crucially, it also includes two mini stock market surges in which shares have moved from being extremely out of favour to flavour of the month. There are differences, but the sentimental journey travelled by investors from March 2020 to December 2021 is not dissimilar to that in the period from the market low in October 2022 to now. In both cases investors shifted from seeking out safe havens to chasing momentum.

So, I looked at the winners and losers from the first of those 18-month upswings and tried to remember what it felt like at the end of 2021, when we were deciding what to do with no knowledge of what the next two years would bring. I compared in particular what my returns would have been if I had stuck with the winners from the previous year and a half or switched horses to the relative losers.

The winners between March 2020 and December 2021 were the punchier equity funds on the Select 50. They were funds which had been beaten up in the pandemic sell-off and had benefited from the V-shaped economic recovery that followed the discovery of effective vaccines against Covid. The Balanced Commercial Property Trust benefited from the end of lockdown, while smaller more economically sensitive companies rallied hard too. The Vanguard Global Small-Cap Index Fund, Fidelity Asian Smaller Companies and Edinburgh Worldwide Investment Trust were among the top performers. The value investment style had one of its periodic moments in the sun, with the contrarian Dodge & Cox investment boutique doing well with both its US and global funds, and the Schroder Global Recovery Fund shone too.

The average gain for the top 10 funds on the list over this period was 95%. Investors nearly doubled their money. So, one quite reasonable option in December 2021 would have been to just stick with these winners. To start with, that momentum approach fell flat as inflation and interest rates took off. Perhaps unsurprisingly, the previous winners were hit hardest. Commercial property, smaller companies and value investing looked less appealing and the average performance of the ten former winners during 2022 was a 10% loss, although more than half of this was delivered by just two of the funds.

What happened next is instructive, however. The funds which had performed best in the first upswing bounced back from the storm of 2022 strongly and over the two years since that first peak eight of the ten have delivered further gains against the backdrop of a market which has overall gone sideways.

The losers in the 18 months after Covid arrived have had a different experience. This list was dominated by bond funds as investors pre-empted the rise in interest rates that the return of inflation triggered. A contrarian approach in December 2021 would have been to invest in the 10 worst performers during that period, almost all bond funds, which had collectively provided investors with a 3% loss. But that would have been a mistake. In the two years since, the ten losers have gone sideways as the bond market rally has been kicked down the road in a higher for longer interest rate environment. Strip out the 24% gain by the iShares Physical Gold fund since the start of 2022 and the other laggards have gone even further backwards.

It is perhaps unfair to distort the momentum versus value debate with bond funds which have endured a uniquely difficult environment over the past four years. So, what would have happened if, instead of picking the absolute losers in December 2021, we had instead backed the also rans, the equity and alternatives funds which had delivered positive but less exciting returns than the ten funds at the head of the pack?

These were the likes of the Schroder Japan Trust, Comgest Growth Europe and Lazard Emerging Markets, funds which rather than doubling like the Select 50’s best performers had instead returned between 15% and 57% in the 18 months after Covid. The answer surprised me. Collectively they have done no better or worse than the post-pandemic losers and less well than the early winners. The winners over the whole period have continued to be those that notched up the best returns in the initial rally in 2020 and 2021 and then held onto their gains.

The main conclusion from all this number crunching seems to be that a simplistic contrarian approach is not the answer. The best-managed active funds that outperform on the way up often then maintain their lead in the corrections. A related conclusion is that the bulk of the market’s gains are captured during short explosive recoveries. Missing out on these is expensive. Far better to hold onto a balanced portfolio and accept that in any given period you will have some winners and some losers. Don’t overthink it.

This article was originally published in The Telegraph.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Please be aware that past performance is not a reliable guide indicator of future returns. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Funds in the property sector invest in property and land. These can be difficult to sell so you may not be able to cash in this investment when you want to. There may be a delay in acting on your instructions to sell your investment. The value of property is generally a matter of a valuer's opinion rather than fact. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.