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21 March 2011Past performance is no guide to future returns?

Is not the time-honoured investment advice to buy low and sell high?

A fresh new study by 3 London Business School (LBS) economists is the latest challenge, in a series of long-running research going back as far as the 1980s, to the efficient market hypothesis.

This hypothesis states that a given asset’s price reflects all available information, therefore responding only to unpredictable news and events. Price, thus, is the true optimal estimate of value at any given point, making it impossible for investors to predict whether that price will move up or down. At least that is the theory. 

However, in 2010 economists Mike Staunton, Elroy Dimson and Paul Marsh took a renewed look at momentum investment, an approach that involves buying the top-performing shares or products of the recent past. They took the largest 100 stocks in the British market since 1900 calculating returns from investing in the top 20 performers over a 12 month period, holding them and enacting a monthly rebalancing of the portfolio.

The result; an investment of £1 in 1900 would, by end 2009, be at £2.3m whereas £1 invested in the lowest performing 20 would have returned just £49. Although this approach uses only the top and bottom 5th of the market, the implication here is that such is the performance of the top 5th that it would represent a better investment than a broad-based buy and hold, i.e. efficient market/undervalued strategy. 

The predominant feature of fine wine investment is to seek out value by way of buying up undervalued stock – buy low, sell high. However, Liv-ex, the wine exchange, applied the momentum approach to fine wine. So in essence, buy high and sell higher still. They came up with some thought-provoking results.

The exchange used the Liv-ex Fine Wine Investables Index, its broadest index covering 24 top-scoring chateaux, taking the top-performing 25% of wines of the previous 12 months as compared to the lowest-performing 25%, starting in June 2000 and re-balancing every year in June. Findings show that a portfolio managed in this way would have brought returns of 390% as compared to 280% for the bottom 25% as per December 2010.

Important issues arise when considering the momentum effect. In an efficient market, the assumption is that the market is rational. However, studies in momentum suggest that irrationality might be playing a hand, whereby investors could buy assets just because they have seen the price rise. This could help explain the appearance of bubbles or why fund managers have placed capital into start-ups or other apparently hot investments with little other plan apparent.

Could this irrationality be occurring in fine wine - in particular Bordeaux classed growths – and if so, how could an investor potentially profit from the effect of this on price formation, gains and losses in the year ahead? 

Just follow the momentum theory then, yes? Well, maybe not because, applying a 5% dealing cost and assuming a churn rate of 50% reduces the top quartile return to 270%, which is almost exactly equal to the performance of a buy and hold strategy of purchasing the entire Liv-ex Fine Wine Investables Index. This strategy, the closest proxy to the efficient market theory, shows a return of 269% in the same time frame.

To complicate matters further, as the same report shows, until mid 2008 it was precisely the bottom 25% that would tend to give the best returns. So what has changed? Since the market shock in 2008, a range of new phenomena can be observed, to do with China, with brands over Parker, aggregate demand and momentum. These have signficantly changed the way the wine market behaves. We try to consider these and other factors relevant to wine investment decision-making over the year ahead. Specifically in the context of a possible softening of demand alongside a slowly widening market and what looks set to be another high-priced – high-quality 2010 en primeur campaign.

We will be discussing these issues and the outlook for 2010 in upcoming blog pieces. 

By James Swann and Mark Schuringa

 Categories: BordeauxInvestment

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