7/15/2014 6:15 PM ET|
Buy hot stocks without getting burned
Chasing after the market's highfliers can lead to trouble, but when used in tandem with a value strategy, momentum investing can improve returns.
After briefly soaring earlier this year, momentum investing -- hitching a ride with the stock market's highfliers -- has come down to earth. For the moment at least.
But because markets go in cycles, momentum strategies will rise again. In the interim, it's timely to look at how hot stocks fit into a portfolio, and how to avoid getting burned by them.
Research shows that winning stocks tend to outperform in the short run, due mostly to enthusiastic and sometimes exuberant buying rather than true fundamentals. "Momentum can be an important contributor to the portfolio," says Gregg Fisher, chief investment officer of investment firm Gerstein Fisher, which includes momentum in its growth-stock strategies. "Past prices do influence future prices."
"The trend is your friend; stocks that are working will continue to work," says Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.
Except when they don't.
"Stocks that are showing strong momentum can fall out of favor quickly," Rosenbluth adds. That's what happened in mid-March with stocks in areas including biotechnology and social media, which had zoomed in earlier weeks.
Indeed, mutual funds and exchange traded funds that pursue momentum strategies have struggled this year in a market lacking volatility. For example, AQR Momentum (AMONX) and AQR Small Cap Momentum (ASMNX) have both lagged behind their respective Russell index benchmarks so far this year, although they have outperformed over the 12 months through June 30. The mutual funds, run by AQR Capital Management LLC, are among the oldest momentum-focused products and are aimed at institutional investors and financial advisers, generally requiring a $1 million minimum investment.
Meanwhile, PowerShares DWA Momentum ETF (PDP) -- the largest ETF of its kind, at a recent $1.3 billion in assets -- trails the Russell 1000 over the past three years but has topped the index over five years.
Part of the challenge for momentum funds is timing. A momentum investor must be nimble, selling stocks that are losing steam and buying whatever is trending. But trading costs add up, so fund managers and ETF providers seek to limit turnover with quarterly or even semiannual rebalancing.
As a result, momentum funds can be left holding yesterday's winning stocks long after the crowd has moved on.
Momentum fund providers counter that trading in response to the market's shifting sands would be worse for investors. A longer time frame diminishes the market's day-to-day noise and confusion, they say.
"Having a reasonable [time] horizon allows you to not turn over the portfolio nearly as much, to capture the intended trend, and not overreact," says Mark Carver, an investment strategist at BlackRock, which offers the iShares MSCI USA Momentum Factor ETF (MTUM).
On the upside, research suggests that investors would do well to add momentum to value strategies, in lieu of the more traditional pairing of value and growth stocks.
Value and momentum are negatively correlated, meaning one strategy is most potent when the other is not. Accordingly, a 50-50 mix of value and momentum improves risk-adjusted returns, according to a 2013 study by Cliff Asness of AQR and professors Tobias Moskowitz of University of Chicago and New York University's Lasse Pedersen.
Momentum strategies aren't right for everyone's portfolio, but if you decide to pursue one, ETFs offer far more choices than mutual funds.
Some momentum ETFs give exposure to specific sectors, such as technology, health care or energy. Others are broader, such as PowerShares DWA Momentum and sibling PowerShares DWA SmallCap Momentum (DWAS), iShares MSCI USA Momentum Factor and SPDR S&P 1500 Momentum Tilt (MMTM).
Each tracks a momentum-focused index that attempts to beat a broad benchmark index by holding stocks displaying higher momentum characteristics, typically over six- and 12-month periods and chiefly based on a measure known as relative strength -- a stock's price gain compared with its peers.
The 115 large-cap and mid-cap stocks in the PowerShares DWA Momentum portfolio are drawn from the Dorsey Wright Technical Leaders Index. The fund on June 30 was heavily invested in growth stocks in the consumer-discretionary, industrials and materials sectors, with Apple (AAPL), O'Reilly Automotive (ORLY) and Precision Castparts (PCP) among its largest individual stakes.
PowerShares DWA SmallCap Momentum, with $487 million in assets at the end of June, follows the 200-stock Dorsey Wright SmallCap Technical Leaders Index. The average stock in the portfolio sports a market capitalization of about $1.9 billion, and health-care, consumer and technology sectors recently accounted for about 55 percent of assets.
Larger stocks dominate both the iShares and the SPDR momentum-driven ETFs.
The iShares fund invests in about 125 companies culled from the 600-stock MSCI USA Index that exhibit the strongest momentum. Health care, industrials and technology on June 30 were the $304 million portfolio's biggest sector weightings, with top holdings including Facebook (FB), Wells Fargo (WFC), Merck (MRK) and Johnson & Johnson (JNJ).
The SPDR ETF, with just $12.5 million in assets, spreads its portfolio across about 1,400 of the stocks in the S&P Composite 1500 index, ranked and weighted in order of relative strength. About half of the assets are given to technology, financial and health-care stocks, with Apple, Microsoft (MSFT) and Wells Fargo holding the top three positions at the end of June. (Microsoft owns and publishes MSN Money.)
When momentum tactics work, such funds stand a good chance to outperform their benchmarks. But that hasn't happened this year with any regularity.
The PowerShares small-cap momentum ETF, for example, has struggled, down 1 percent for the year through June 30, versus a 2.5 percent gain for the small-cap Russell 2000 Index (RUT).
Momentum's current weakness has affected large-cap ETFs as well. PowerShares DWA Momentum rose 6.4 percent in the first half, trailing the S&P 500 ($INX) by almost a full percentage point; the iShares fund, meanwhile, lags behind the related iShares MSCI USA ETF (EUSA) by more than one percentage point.
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