Investing: Keeping up with momentum strategies

• Momentum strategies unpopular since 2000-2002 bear market
• Value strategies taken in the past decade
• A few funds still chase momentum

In June 1861, a young Confederate soldier learned that objects in motion tend to stay in motion: A Union cannonball ripped through his leg during the Battle of Philippi in West Virginia. The soldier, James E. Hanger, was sent home, minus his leg — the first amputee of many in the Civil War.

Several months later, Hanger startled his family by walking down the stairs of his home in Churchville, Va., having whittled a leg out of barrel staves. He went on to found the J.E. Hanger Company, which manufactures artificial limbs to this day.

Investors can learn a great deal from Hanger — perseverance being just one — but today, we'll talk about how momentum applies to investments. Stocks in motion, like cannonballs, tend to stay in motion. But you have to remember the rest of Newton's law, the part that Hanger learned the hard way: Objects in motion will stop, often unavoidably, when something gets in their way.

Momentum investing means, in its simplest form, buying a stock (or mutual fund) that is rising faster than normal, and hoping that it continues to do so. To the untrained eye, this might sound like the naïve strategy of buying whatever is going up. And, well, it is.

What's more peculiar, according to numerous academic studies, is that momentum does seem to produce above-average returns, at least in the short run. A recent paper by Ryan Larson of Research Affiliates, a Newport Beach, Calif., investment firm, looked at how momentum strategies have fared through the years.

"Momentum has shown itself to be quite robust across U.S. and foreign equity markets, within industries and countries, and across many different asset classes such as stocks, currencies, commodities, and bonds," Larson writes. "Other academics confirmed that momentum is at work in international equities, emerging markets, industries and sectors, mutual funds, and asset classes. In fact, commodity trading advisers have built a profitable business around trading momentum."

If you've watched the stock market for any amount of time, you've probably noticed that Wall Street's darlings often have runs of 12 to 24 months before they fade from favor. Gilead Sciences, a red-hot biotech firm, rose 44.6% the 12 months ended Aug. 31, 2012, according to Standard and Poor's Capital IQ. The stock has soared 107% in the past 12 months.

A more prosaic example: Home Depot, which jumped 70% the 12 months ended Aug. 31, 2012. The stock has risen 31% the past 12 months, handily beating the Standard & Poor's 500 stock index.

Mutual funds, too, often have relatively long winning streaks. A study by The No-Load Mutual Fund Investor, a highly respected newsletter, looked at the results of buying the top-performing diversified U.S. stock fund each year. (The newsletter looked only at funds that don't charge a load, or sales charge). As of 2008, the system had beaten the average no-load fund in 21 of the previous 32 years, gaining an average of 18.8% from 1975 through 2008.

Or consider a 401(k) portfolio that consists of five funds: a large-cap fund, a midcap fund, a small-cap fund, a government bond fund and a money fund. Every three months, you put your money into the fund that's had the best 12-month record. For example, on July 31, 1993, the midcap fund had gained 23.4% the previous 12 months. (We're using the Lipper index for each category, which measures the performance of the largest fund in each category).

Because the midcap fund fared best, you put your money into the midcap fund for the next three months — July 31 through Oct. 31, 1993. Your gain: 10.6%. Midcap funds would continue to lead for the next five quarters. From July 1993 through July 2013, the system would have turned $10,000 into $62,000, vs. $55,000 for the S&P 500 with dividends reinvested.

Academics are at a loss as to why momentum works. In the case of Gilead, whose drug, sofosbuvir, treats hepatitis C more efficiently than previous treatments, the answer might simply be increased earnings. And companies such as Gilead and Google may have such a tremendous reputation for innovation that investors are willing to pay higher prices — at least until they suspect such innovation will stop.

And there's the problem. Momentum stocks and funds tend to stop suddenly and messily, as investors in technology stocks discovered, to their horror, in the technology crash of 2000-2002. Mutual fund momentum strategies require lots of attention to timing, and fund investors typically buy funds to avoid just that. The above example of timing requires that you be prompt in moving from one fund to another, a process that not only requires discipline, but can also result in short-term taxable gains and other transaction costs.

The 2000-2002 bear market put such a hurting on momentum funds that the practice has largely gone the way of applying leeches in medicine. This might be an argument in favor of momentum: When the world consists of value investors, it might not be too bad to be the only momentum person. For those who are interested in someone else doing the momentum investing, Alex Byran of Morningstar suggested the AQR funds, which offer AQR Momentum (AMOMX), AQR Small Cap Momentum (ASMOX), both of which are in the top third of their Morningstar categories.

For most people, though, momentum is a strategy best left to others, or at least limited to a small and aggressive portion of your portfolio. Otherwise, you could find yourself missing a portion of your portfolio that you hadn't intended to lose.