Momentum is on a roll. But will it last?

If your clients don't have a long holding period and an appetite for risk, it might be better to wait until momentum cycles in and out of style once again.

Oct 9, 2017 @ 12:00 pm

By John Waggoner

+ Zoom

In the Great Circle of Life, everything comes back eventually. Vinyl albums, Swedish modern furniture and Marvel superheroes are all good fun. But no one really wants fallout shelters, air raid drills and flint tools to make a comeback.

In the investment world, however, one trend is clearly back, and that's momentum investing. That's a good thing for now, but you should remember what happened to them the last time they roared.

Momentum investing is a subset of growth investing, which means investing in stocks whose earnings are projected to rise more rapidly than other stocks. In its simplest form, momentum simply means buying whatever is going up the most, and selling it when it loses steam.

There is nothing inherently wrong with momentum investing. The herd on the street may be wrong at turning points, but it's often right the rest of the time. One could argue that any index using capitalization weighting — such as the Standard & Poor's 500 stock index — is a form of momentum investing. After all, the index gives greater weight to those stocks that have risen the most.

Right now, momentum is working overtime, according to a recent study by Morningstar's Tom Lauricella. "Since the start of 2017, momentum — which measures how much a stock has risen in price over the past year relative to other stocks — has been by far and away the most significant factor explaining performance," he wrote. "Investing in one more unit of momentum has added nearly 6% return to a portfolio."

The resurgence in momentum explains several things, not least of which is the outperformance of growth funds this year.

The average large growth fund has gained 18.08% this year, vs. 8.65% for the average large value fund. And, according to Mr. Lauricella, the higher a fund's exposure to momentum, the better its 2017 returns tend to be.

One example: iShares Edge MSCI USA Momentum Factor ETF (MTUM), a straight-up momentum strategy ETF that's gained 27.71% this year. The $4.1 billion fund has momentum of its own: It has attracted $1.6 billion the past 12 months.

Generally speaking, the actively managed funds with the strongest ratings for both growth and momentum have been this year's top performers among diversified stock funds. Transamerica Capital Growth (TFOIX), up 32.23%, for example, had one of the highest momentum rankings. So did Morgan Stanley Institutional Growth (MSEQX), up 31.88%.

Not all momentum strategies are equal, said Todd Rosenbluth, director of ETF and mutual fund research at CFRA. "The trend has been your friend, but the devil is in the details of how you go about it." PowerShares S&P 500 Momentum (SPMO), for example, has gained 17.75% — less than the average large-company growth fund. Unlike the iShares offering, which includes mid-cap stocks, the PowerShares ETF sticks with large, blue-chip stocks.

If this sounds familiar, it should. Back in 1999, the SSGA Aggressive Equity fund racked up a 120% gain for the year, according to Morningstar. It was a classic growth fund, looking for stocks of companies that are "undervalued relative to their growth potential." The fund, which fell at an 18.49% average annual rate during the 2000-2002 bear market, liquidated in 2008.

The fund was in good company. Morgan Stanley Market Leaders gained nearly 50% in 1999, and was merged away after the bear market. So was Columbia Value and Restructuring, up 42% in the great bull market. Not all of its momentum-based peers liquidated, of course. Pin Oak Equity, up 98.12% in 1999, took a 51.66% licking in the bear market, but kept on ticking. It's up 20.8% the past 12 months, despite a 10% cash position.

"Momentum works until it doesn't," Mr. Lauricella said. And for advisers, that's the difficulty. Because momentum is a reasonable strategy for long periods of time, it will produce decent returns for those with the fortitude to stay with momentum funds or the foresight to get out while the getting is good. The odds are better for those with fortitude: The S&P 500 has gained an average 5.08% since the top of the dot-com bubble in March 2000. Morgan Stanley Institutional Growth has gained 5.64%.

At least for now, momentum remains in the groove. But investors in those funds are steadily accumulating some of the most expensive stocks in the market. If you think your clients don't have a long holding period and a high risk tolerance, it might be better to wait until momentum cycles in and out of style once again.

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