Chet Currier—Momentum Investing Not a Wise Long-Term Approach

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These are chastening days for many people who call themselves “momentum” investors.

If you bought stocks or stock mutual funds that were racing ahead a year ago at this time, you crashed when the market took a hairpin turn soon afterward. As Jan and Dean’s Law states, “Dead Man’s Curve, it’s no place to play.”

Look at the Janus Twenty Fund, which attracted a huge following with gains of 73 percent in 1998 and 65 percent in 1999, then dropped 32 percent in 2000. Dozens of other growth and aggressive growth funds hit the same wall.

The Berger New Generation Fund, up 144 percent in 1999, fell 39 percent the next year. The Putnam Voyager II Fund’s Class A shares, up 80 percent in 1999, dropped 32 percent in 2000.

We haven’t even mentioned specialized Internet funds and others in the “technology” category. Take the Amerindo Technology Fund’s Class D shares up 249 percent in 1999, down 65 percent last year.

“An important lesson from 2000 is that momentum is not a valid long-term investment strategy,” said Jack Brennan, chairman of the Vanguard Group, the second largest fund firm with $564 billion in assets. “It’s a ‘greater fool’ strategy. The last person in pays a high price.”

Let’s be careful what we mean by “momentum.” Some fund managers who use that label referring to changing rates of corporate earnings growth have posted admirable long-term records.

Favored few

A few professional traders in futures and options are legendary for their ability to get aboard and ride a fast-moving market trend. That’s momentum-playing at its most successful.

But Brennan’s point strikes home for investors in mutual funds, a vehicle that has shown itself over the decades to be ill suited for just about every fast-money strategy ever tried.

One of the most common traps to fall into is using performance results from the latest year to try to pick funds for the next decade or two. “That’s the bane of our business,” Brennan said. A new study is at hand to support him.

In the 1990s, fund investors’ frequent trading in pursuit of the hottest funds cost them 20 cents of ever dollar in gains they could have realized with a buy-and-hold approach. What could have been an average 10.9 return for a sit-tight investor worked out, in reality, to only 8.7 percent in practice, according to Phoenix.

The study, done for Phoenix by Financial Research Corp. of Boston, arrived at those numbers by tracking flows of money into and out of funds along with the funds’ quarterly investment performance.

Flowing with the go

Not surprisingly, it found that investors gravitated to funds that had been doing well lately. Flows of money into funds after the quarters in which they posted their best gains of the decade were 14 times greater than flows after the funds’ worst-performing quarters. Phoenix concluded: “Contrary to their best interests, many investors are purchasing funds based on past performance, usually when they are already at or near their peak.”

Now, I’m aware that this study suits the purposes of a firm like Phoenix specializing in broker-sold funds. The firm uses it to argue that investors who go it alone are trading too much, and need a paid adviser to guide them along a more patient path.

Even so, the numbers strike me as credible and instructive. All the evidence I have seen supports Phoenix’s observation that “investors think long-term in theory but act according to short-term influences.”

If this is the ailment, what’s the antidote? Picking funds according to your needs and goals rather than from the performance hit parade.

“Momentum investing is dangerous,” says Ken Gregory in his newsletter No-Load Fund Analyst, based in Orinda, Calif. “Yes, it works sometimes. But in the long run, everything comes back to economic value.”

Chet Currier is a columnist for Bloomberg News.

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