Anomalies, Cycles, and Inevitable Periods of Underperformance

You’re new to investing and want to pursue a small-cap value strategy. You’ve read that value stocks and small caps tend to outperform over time and you, of course, would like to outperform.

Looking at back at history, following such a strategy seems like an easy ride. An investment of $10,000 in 1979 would have grown to $829,578 in the Russell 2000 Value Index versus only $299,945 for the Russell 2000 Growth Index (annualized return: 12.9% vs. 9.8%).

Image of Russell 2000 value and Russell 2000 growth

In reality, though, sticking with small-cap value was anything but easy. There were many periods in which value underperformed growth. In fact, in looking at rolling 3-year returns, value underperformed growth 33% of the time. That means value was deemed to be “not working” or “broken” in one-third of all rolling 3-year periods.

Rolling 3 year returns of Russell 2000 value from 1982 to 2014

This is where we are today. Value has underperformed growth by over 25% in the past three years. How many investors, given this backdrop, would choose value over growth? Not many.

And this is far from the worst period in history for value. At the end of February 2000, value had underperformed growth by 85% in the prior three years. Those selling value strategies at the time were literally laughed out of the room. We all know what happened next.

The moral of this story: all anomalies have cycles and periods of underperformance. It seems counterintuitive, but this is why they work in the first place. If there was a strategy that worked every month of every year, everyone would follow it and it would stop working.

In our 2014 paper on Beta Rotation, we illustrated a rotational strategy that outperformed the broad equity market in 80% of rolling three year periods. Notable outperformance, but this still meant the strategy was underperforming 20% of the time. And when you’re in one of those periods, it can feel like an eternity.

Rolling 3 year outperformance image from 1929 t0 2013

How should investors think about periods of relative underperformance?

If they maintain a diversified portfolio of asset classes and factors (as they should), they need to accept the fact that by definition, something in their portfolio will always be underperforming. I agree, this is not easy to accept, but it is a mathematical truism. The prudent investor will welcome such underperformance as an opportunity to rebalance and add to the factor or asset class that may now be undervalued.

Most will do the opposite, emotionally chasing asset classes or factors only after they have shown strong performance and selling whatever “isn’t working” in the short run. Unfortunately, chasing after the hottest fads is not a particularly successful investment strategy.

The best example of this today is in biotech stocks. Many new investors are just learning about the biotech boom in which we recently saw shares quintuple over the past five years. They see the chart below and instantly fall in love, projecting past returns into the future.

S&P 500 and Biotech index ETF image

“Charlie, what do you think of biotech stocks?”

That is the most popular question I have been asked in recent weeks and tells you all you need to know about human psychology (certainly no questions on value stocks). Everyone loves a winner. I get that, which is why momentum exists and is one of the most powerful forces in markets.

But momentum, too, has cycles and few investors are willing to accept the drawdowns, volatility, and periods of underperformance that come along with such a strategy. Fewer still have a consistent process by which they try to take advantage of the momentum factor. Chasing performance years after a run is not the same as short-term momentum. There will many Johnny-come-lately biotech investors that learn this the hard way.

In the end, it all comes back to psychology. Can you accept the fact that something will always be underperforming in a diversified portfolio and use that to your advantage instead of giving in to your emotions? Can you ignore the noise of the short-term and understand that the path to successful investing is not paved by winning yesterday’s war and engaging in “what ifs,”  but by realizing the future is not the past. If you can, you’ll be investing often in things that “aren’t working,” but end up way ahead of those investors who believe that everything in their portfolio should be up at all times.


This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.


Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.


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