Some pros challenge the conventional wisdom that investors get burned by betting on recent winners

Journal Reports

In the wake of the crash and unpredictable recovery, more investors are growing disillusioned with fundamental methods of stock picking. Individuals and mutual-fund managers alike are betting that the best way to beat the market is to buy stocks that have already been heading up. And they’ve got lots of professional opinion on their side.

Recent studies show that a rotating cast of stocks with upward price momentum consistently beats the market, and works particularly well as diversification for bargain-hunting value portfolios. What’s more, some investing pros say we’ve entered an era well suited to momentum strategies—where one asset after another experiences a bubble that then bursts.

In less than three years, for instance, the broad Standard & Poor’s 500-stock index fell more 55% and then boomeranged back to within 25% of its all-time high.

In the old days, that might have taken 10 years or 15, 20 years, says Phil Orlando, a veteran portfolio manager with Federated Investors.

We’re in a different regime in terms of markets, says Christian Hviid, chief market strategist for Genworth Financial Asset Management, a unit of Genworth Financial. A new reality has set in. It’s not about just being Warren Buffett and being patient, and holding things for 20 years. Rather, it’s taking advantage of things that change and evolve over time with different episodic drivers.

A New Gauge

ENLARGE

Boris Kulikov

Many mutual-fund managers have taken these ideas to heart. Mr. Orlando of Federated Investors says the turnover rate—or speed at which funds rotate holdings—and the trading volume at funds have ballooned in the past 30 years.

In a sign of just how popular this idea is becoming, Morningstar Inc. this summer will roll out a new gauge: The research firm will assign U.S. and international stocks a score between 1 and 100 for momentum and take the mean momentum score of a mutual fund’s holdings to give the fund an overall momentum ranking. If funds that consistently score highly on momentum perform similarly, Morningstar might eventually create a new category of momentum-oriented funds, says John Rekenthaler, vice president of research at the firm.

It’s just time for the new momentum gauge, Mr. Rekenthaler says.

For many years, academic researchers believed a stock’s performance could be explained by three primary factors: the market where the stock traded, the size of the company, and the stock’s style, along a continuum from shares of fast-expanding growth companies to seemingly cheap value stocks.

But now, the academic community has coalesced around recognition of momentum as the fourth factor, says Mr. Rekenthaler, a sentiment echoed in recent research.

The missing ingredient in the market is a momentum index, wrote Jon Eggins, of Russell Investment Group, and Robert Hill, an economics professor at Australia’s University of New South Wales, in a 2008 study. This is particularly important given that large numbers of investors follow contrarian and momentum strategies…The same is true of mutual funds.

The academic work that quantified how factors of size and style affect stock returns dates back to the early 1990s.

University of Chicago professors Eugene Fama and Kenneth French produced studies showing that smaller stocks and value stocks tend to deliver higher returns than larger stocks and growth stocks over long periods of time, partly because they carry higher risk.

Shortly thereafter, some of their colleagues at the university produced another curious finding: The recent track record of stocks could be a good predictor of their future short-term moves.

These momentum trends in markets have more to do with the faddishness of human behavior than the fundamentals of economics and balance sheets. In essence, investors often flock to the stocks that have been going up, which tends to propel them further.

Momentum, or momo, traders don’t analyze why drug stocks, say, are on a winning streak recently or determine whether the stocks are expensive or cheap in theory. Momentum seekers jump on the bandwagon, intending to jump off again before the inevitable train wreck that ends the journey.

With so many traders watching the same charts and seeing the same signals, these trends often become what Mr. Hviid of Genworth describes as a self-fulfilling prophecy.

The dot-com bubble was an extreme example of a momentum trade—and illustrates the way the strategy amplifies both returns and losses. Turner Midcap Growth Fund. for instance, more than doubled in value in 1999, but it lost more than 50% over the next three years. Hedge funds, meanwhile, used momentum strategies in the commodities bubble of the early 2000s and the junk-bond and gold rallies last year.

Because it’s so closely tied to big, risky bets, the m-word carries negative connotations for many investors. But advocates of the strategy contend it’s no more speculative than value or growth investing.

Consider the argument from Clifford Asness, one of the leading proponents of momentum strategy for the average investor. Mr. Asness is managing principal of hedge-fund firm AQR Capital Management, which has attracted about $45 million to three momentum-focused mutual funds it launched last summer.

Mr. Asness co-authored a 2009 study entitled Value and Momentum Everywhere, which suggested that investors can hedge themselves and boost returns with a simple combination of momentum and value strategies—in stocks and all other asset classes.

In the past, many investors looked to hold a mix of value-oriented and growth-oriented stocks or funds, since the two were thought to take turns in favor. Now AQR suggests that momentum, rather than growth, is the right foil for value strategies.

In a separate study called Case for Momentum, AQR principal Ronen Israel and colleagues back-tested the performance of a new AQR momentum index from 1980 to 2009, and compared it with the performance of growth and value indexes.

AQR’s momentum index was built by picking the top third of the largest 1,000 U.S. stocks based on relative price performance in the prior 12 months. The index is rebalanced quarterly. During the back-testing period, the momentum index beat the Russell 1000 Growth Index by an average of three percentage points a year. The momentum index also had a negative correlation with the Russell 1000 Value Index, unlike the growth index. The study had similar findings for a small-cap momentum index.

Momentum can be hurt in periods where there are very sharp reversals in the marketplace, and in particular we saw this in the spring of 2009, says Mr. Israel. Oftentimes, that’s when the cheap stocks, the value stocks, are going to do very well. When you get into the tech bubble in the late ’90s and early 2000, you had the opposite effect.… In that situation, the value strategy does very poorly but momentum helps you. The two interact, and the combination’s very strong.

The Danger of Crowds

Still, some professional investors say individual investors shouldn’t be trying to adopt momentum strategies on their own.

Try it at your own peril, says Quincy Krosby, market strategist at Prudential Financial Inc. After all, individuals have a sorry history of jumping into and out of asset classes at just the wrong time.

Our worry is that the average retail investor stays in [a hot area] until the very end and then waits until it bursts, Ms. Krosby says. That happened in the dot-com era: When an adviser would tell clients that the tech sector looked too frothy, she says, the clients would go to somebody else because they didn’t want to hear it.

With momentum, Ms. Krosby says, you do make money, [but] you can also lose it in a nanosecond.

David Kovacs, chief investment officer for Turner Investment Partners, which uses a momentum strategy based on earnings growth rather than price increases, says investors get excited because momentum beats the market on the way up—and often forget that it gets hammered more than the market on the way down.

The pros who use momentum strategies argue that a disciplined approach helps them stay on top of trends.

At the end of every month or every quarter, they look at the strongest and weakest stocks in the market, and rotate investments in and out accordingly. They still get stung during the worst months or quarters for the market, but they say the data show the strategy works over the long term.

There is one other way fund investors can work with momentum strategies: by pre-empting them. Like talent seekers at a record company, Mr. Hviid of Genworth Financial says his team tries to figure out what the next big thing in momentum will be. In addition to number crunching and economic analysis, Mr. Hviid and his team make assessments of whether a critical mass of other investors and traders will follow them into a given investment.

Last year, this assessment helped lead Genworth to junk bonds. This year, Mr. Hviid believes that Asian bonds, which have fatter yields than U.S. Treasurys, may soon draw buyers.

Mr. Curran is a writer in Denton, Texas. He can be reached at