Funds with momentum

Investors Chronicle's economist, Chris Dillow, who is a big fan of momentum investing, says: "Over time the strategy of buying the best-performing stocks of the previous period and holding them for the next period has trounced many benchmark indices around the world."

Academic research has found that a momentum return premium is evident among US equities over the 212 years from 1801 to 2012, and UK equity data going back to the Victorian era also suggests this. The effect has also been recognised in 40 other countries and in more than a dozen other asset classes.

And investors do not need to have a very tight definition for what period to use when looking for companies with momentum. Researchers have considered a range of time periods for the top-performing stocks of the past three to 12 months, and the evidence that momentum works remains compelling, Mr Dillow says.

"There are many different types of momentum strategy," says Darius McDermott, managing director of Chelsea Financial Services. "One example, popular with many fund managers as a part of their wider investment process, is earnings momentum. The theory goes that companies that have beaten earnings expectations once are more likely to do so again."

The reason for this is that investors are often slow to recognise a change in a company's performance. Investors Chronicle's economist, Chris Dillow, who is a fan of momentum investing, says: "People are basically prejudiced: we stick to our beliefs - even when we see contrary evidence. And that matters for investing as people react less to a piece of evidence such as an earnings increase at a company and this leads the share price not to move very much."

Instead what tends to happen is a gradual shift upwards in the share price or, if there is negative news such as a profit warning, a gradual shift downwards in the share price.

This phenomenon, known as post-earnings announcement drift, is one of the reasons why momentum investing can be so successful.

Losing momentum

However, while some fund managers look at earnings momentum as part of their wider analysis, not many funds invest only taking momentum into consideration.

"Momentum investing takes a lot of expertise to get right," says Adrian Lowcock, investment director at Architas. "The risk is that a fund can end up being full of popular and expensive stocks, for which even a small piece of bad news can undermine the price."

Momentum investing can work quite effectively until there's a turning point in the market. Last year was a good example of this, when there was a swing in investor sentiment from growth stocks to value and recovery stocks. These shifts in the market can be hard to predict and can cost a fund manager dear if they fail to recognise a change in the market.

"Last year was a relatively mild switch, but the risk is that you get caught out by a big market reversal or market crash," says Mr Lowcock. "What goes up further often comes down faster and we saw this in the tech boom. If you were following a momentum strategy then you'd have been in the tech stocks that were doing really well, but they suffered the most when the bubble burst."

Mr Dillow acknowledges there are similarities between momentum investing and the development of an investment bubble. "Bubbles happen when people are buying things other people are buying," he says. "The evidence shows that the art of momentum investing is to get in at the bottom of a trade. But the problem with bubbles is that they burst."

As well as being vulnerable to sudden changes in the market, momentum investing is also more likely to lose money in a volatile market. "At the moment, volatility is very low - perhaps too low - and we could also see this increase in the coming months, particularly when the Brexit negotiations start in earnest and we have the French and German elections," says Mr McDermott. "With equity markets in the UK and US at all-time highs, and eight years into a bull run, there are now questions as to whether they can continue to rise or whether we will see a correction."

Another drawback is that momentum investing requires managers to be very active in trading in and out of stocks, which means higher trading costs, and this eats into end investors' returns.

As a result of the risks, Mr McDermott suggests only having a small proportion of your portfolio in funds that take a momentum approach, as a supplement to your core holdings.

Funds that take a momentum approach

One of the asset managers that partly employs a momentum approach in some of its funds is Marlborough.

"The managers of Marlborough UK Micro-Cap Growth Fund (GB00B8F8YX59) start off with a very diverse portfolio of 200 small holdings," says Mr McDermott. "They then add to the stocks that do well and quickly cut stocks that do badly. This strategy has worked extremely well with this fund and Marlborough Special Situations (GB00B907GH23)."

Standard Life Investments, meanwhile, has a proprietary tool called the 'Matrix', which uses price and earnings momentum as part of its managers' investment processes. For example, Wesley McCoy, manager of Standard Life Investments UK Equity Unconstrained (GB00B0LD3C08), avoids what he calls "structurally challenged" stocks and instead seeks ones with upward momentum, growing earnings and the potential for dividend increases. This fund, which is ranked in the UK All Companies sector, has an ongoing charge of 0.9 per cent.

Mr McDermott also highlights Standard Life Investments UK Ethical Fund (GB00B6Y80X40), which aims to provide long-term growth by investing in a diversified portfolio of UK equities that meet strict ethical criteria. This criteria is agreed by the Standard Life Ethical Funds Advisory Group. The fund is managed by Lesley Duncan and has an ongoing charge of 0.9 per cent.

Harry Nimmo runs funds including Standard Life Investments UK Smaller Companies (GB00BBX46183), Standard Life Investments Global Smaller Companies (GB00BBX46522) and Standard Life UK Smaller Companies Trust (SLS), and uses momentum.

"Mr Nimmo favours companies with an entrepreneurial streak and high levels of management participation in the business, so many are founders of their businesses," explains Mr Lowcock. "His focus is on sustainable growth, high-quality companies and earnings momentum. He will also hold on to his winners as they deliver - which many smaller company fund managers do not."

Mr Lowcock also likes Artemis Capital Fund (GB00B2PLJM64). This aims to provide a balanced spread of investments for long-term capital appreciation by seeking well-managed companies, primarily in the UK, which display superior potential for earnings growth.

"The manager, Phil Wolstencroft, invests via a value style but using Smart GARP [growth at a reasonable price] - a tool looking at a number of factors including earnings revision and momentum," says Mr Lowcock. "He focuses on owning stocks which are being upgraded, and he has a tendency to ride his winners and cut the losers."

Performance

Source: Morningstar as at 24/03/2017, *Performance shown is for a different share class to that mentioned in the text