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The Wisdom of Herds

Following momentum's 2010 comeback, is there a role for the tactic in your portfolio?

Despite ample evidence that momentum-based strategies can work, fundamentally focused investors can sometimes be dismissive of them. Facts can be stubborn, though. After taking a drubbing during the 2008 debacle and, in relative terms, 2009 as well, the strategy returned to historical form in 2010, with each of AQR's momentum-based indexes--U.S. Large Cap, U.S. Small Cap, and International--besting their relevant, market-cap-weighted counterparts by significant margins.

Launched in July 2009, moreover, the shop's AQR Momentum (AMOMX) delivered a strong first full calendar year, too, surpassing the large-growth category norm by more than 3 percentage points en route to a gain of 18.6%.

Rewards ...
Momentum gets a bad rap in part because it seems too easy. Rather than poring over a company's financials, assessing its executives, and constructing elaborate valuation models, momentum investors ask a single question--what's working now?--and invest accordingly. There are variations on the approach--some momentum strategies incorporate earnings data and relative strength among their criteria--but one remarkably simple tack has enjoyed remarkable success.

In a paper published last year, Tom Hancock--co-head of GMO's global quantitative equity team--found that, between 1927 and 2009, a strategy of investing in the top quartile of stocks based on trailing 12-month returns outperformed the market by an annualized 3%. One common variation--excluding returns generated in the 12th month of the time series--outperformed by an annualized 4%.

... and Risks
Momentum-based returns come with plenty of potential risk, though. Turnover (and therefore transactions costs) can be high, taking a bite out of those outsize returns. The tactic can tank during downturns, too, with the market's highest fliers having the farthest to fall when sell-offs ensue. Nor is there a guarantee that momentum purists will enjoy full participation in a given rally: Shellacked during the market's 2008 debacle, the strategy badly underperformed amid 2009's dramatic rally, too.

The take-away from 2010's reversal of fortune, however, isn't that momentum is "back." Rather, it's that, like all winning investment approaches, this one requires patience. It's best used in tandem with other strategies, too. Savvy asset allocators, for instance, might consider carving out just a sliver of their pie charts for momentum. Doing so can add not just potential for market-beating returns but also a layer of strategic diversification as well.

That's particularly true, I'd argue, for folks whose lineups may tilt heavily toward valuation-sensitive bottom-up stock-pickers, dyed-in-the-wool "fundamentalists" who rely on discounted cash-flow analysis for their work. We don't often think of it in risk-centric terms, but exposure to that strategy constitutes a risk factor, too: Like momentum, it's an approach destined to fare better in some markets than others.

Three Contenders
In the December issue of Morningstar FundInvestor, I profiled a number of well-established momentum funds, among them:  Chase Growth  (CHASX), whose quality bias buoyed relative performance during 2008's downturn, and  Brandywine Blue (BLUEX), which took it on the chin that year.  

A recent offering from Houston-based quant shop Bridgeway Capital Management looks intriguing, too. Launched last May, Bridgeway Small-Cap Momentum (BRSMX) targets an area of that market that's been the shop's historical sweet spot: small- and micro-cap companies. With an annualized gain of 15.7% for the 15-year period that ended December 2010, for example, the shop's  Bridgeway Ultra-Small Company (BRUSX) not only sits atop the small-growth category over the stretch but also places fourth among all domestic-stock funds with track records of at least 15 years.

Bridgeway Ultra-Small Company is currently closed to new investors, but would-be shareholders should give Bridgeway Small-Cap Momentum a look. Its momentum screen differs from Ultra-Small Company's, and it sports a far larger average market cap as well. The newer fund, however, looks comparatively svelte relative to its typical small-blend rival, weighing in with an average market cap of $1.2 billion versus a category norm of $1.8 billion. That owes in part to a micro-cap sleeve that soaks up nearly 14% of assets. (The category norm is roughly 3%.)

The fund also stands apart from the peer-group pack in terms of its current portfolio, which tilts toward growth--not uncommon for momentum vehicles during periods when the strategy is in favor.

Another Approach
For those inclined to complement their portfolio's fund lineup with individual stock picks, our  Premium Stock Screener's momentum filter can come in handy, too. Drawing on earnings data, the trajectory of analysts' estimates, and relative strength criteria, the screen is particularly helpful when used in conjunction with more qualitative criteria.

Currently, for example, nearly 270 stocks make it through the momentum screen alone. Adding a requirement for grade-A financial health, however, eliminates 200 of those names. Filtering that subset of stocks for those that Morningstar Equity Research rates as having compelling competitive advantages (that is, "wide moats") whittles the contenders down to just a dozen possibilities.

Preview of Coming Attractions
I'll dive further into this topic in future columns, including a look at whether (as the paper from GMO's Hancock seems to suggest) price momentum isn't just a "technical" tactic but perhaps a leading indicator of improving fundamentals, too. Stay tuned for that, and if in the meantime there are questions you have or aspects of momentum you'd like to see covered, be sure to drop those ideas into the comments area below.

Shannon Zimmerman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.