Past performance is no guide to future returns? Bordeaux 2010

To buy low and sell high. Is this not the time-honoured investment advice?

The latest in a series of long-running research articles began in the 1980s, published by 3 London Business School (LBS) economists is the latest challenge to the efficient market hypothesis.

In theory a given asset’s price is a reflection of all available information and therefore it’s true market value where price only responds to unpredictable news and events. 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 momentum approach has been applied to fine wine by Liv-ex, a wine exchange who set it against the traditional purchase of underrated stock. The results prove interesting reading, a kind of buy high and sell higher approach.

Liv-ex took the top and then bottom 25% of it’s benchmark Fine Wine Investables Index, it’s broadest, beginning in June 2000 re-balancing each year until June 2010. The results, a portfolio manages in this way would have yielded 390% for the top chateaux as compared to 280% for the bottom 25%.

In an efficient market the assumption is that the market is rational. however studies suggest that irrationality may also play a hand whereby investors may be buying stock when they see it move. This raises important issues when considering the momentum effect, as it could help explain where bubbles come from, or why fund managers may place caital in apparently hot inevestments or start-ups with little appearance of any plan.

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?

With fine wine, the closest proxy to the efficient market theory is a buy and hold strategy. Should we follow the momentum theory then? Maybe, but it is not quite like that. If we apply 5% dealing costs and assume a churn rate of 50% we see the top quartile return at 270%, which is almost exactly equal to the performance of the buy and hold across the Liv-ex Fine Wines Investables Index.

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 another high-priced – high-quality 2010 en primeur campaign.

We will be discussing these issues and the outlook for 2011 in upcoming blog pieces.

Ditton Wine Traders is a wholesaler offine winesfrom Bordeaux and equivalent wines fromBurgundyand Italy