Momentum Funds Are Out of Favor: Buy!

A momentum strategy -- knowing outperformers often keep it up -- can help diversify portfolios.
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NEW YORK (TheStreet) -- Decades ago, academic researchers reported an intriguing finding about market momentum: If a stock outperformed for 12 months, it was likely to continue shining for another three to 12 months.

Inspired by the results, companies began introducing momentum funds. The funds typically aimed to buy stocks with climbing share prices or accelerating earnings. Over the years, momentum managers soared in bull markets. But the funds crashed during downturns when hot stocks suddenly turned ice cold.

Throughout the bull market of the 1990s, momentum funds delivered top results. In recent years, many funds have lagged because they suffered during downturns. That soured investors from trying momentum strategies. But the time to buy momentum funds is when they are out of favor. If markets revive in the next year, high-octane momentum funds will likely be among the leaders.

Whether or not stocks rally, momentum strategies can help to diversify portfolios, says Ronen Israel, a principal with AQR Capital Management. "Momentum strategies sometimes do well during periods when value stocks and other investments are lagging," he says.

To give investors a pure dose of momentum, AQR has developed an indexlike fund,

AQR Momentum

(AMOMX) - Get Report

. The portfolio managers screen the 1,000 largest U.S. stocks and buy the 300 names that have delivered the best performance in the past 12 months. The process is repeated every quarter.

While AQR Momentum holds some growth stocks, it is very different from traditional growth index funds, Israel says. In the traditional approach, the index designer takes a benchmark -- such as the

S&P 500

-- and divides the stocks based on their valuations. The most expensive stocks go into a growth index fund, while the cheaper stocks are assigned to a value index. In contrast, AQR ignores valuations. It takes any stocks that are rising. The resulting portfolio includes a mix of growth and value names.

This gives the momentum fund an advantage over growth funds, Israel says, because value has outperformed growth most of the time. "A momentum index captures stocks that are showing signs of improvement," Israel says. "A growth index holds fully priced stocks."

The AQR fund started last year, and so far it has been performing as the managers hoped. During the past year, the fund has returned 14.1%, outdoing the S&P 500 by 6 percentage points and surpassing 95% of large-growth funds, according to

Morningstar

(MORN) - Get Report

.

Investors who prefer an actively managed momentum fund should consider

Monetta

(MONTX) - Get Report

, which has returned 3.9% annually during the past five years, outdoing 88% of large-growth funds. An aggressive fund, Monetta does especially well during bull markets. Last year, the fund returned 48.7%, outdoing the S&P 500 by 22 percentage points. That makes Monetta an appealing choice for investors who expect the market to rally.

Portfolio manager Robert Bacarella only buys a stock when a variety of indicators are positive. The earnings and share price must be performing well. In addition, the company must be publicly predicting that good earnings results will continue. "I would not buy a stock just because it made a minor move," Bacarella says. "I want to see the stock up 10%, and I want to have a high degree of confidence that the upward trend will continue."

Bacarella especially likes to buy stocks in sectors showing momentum. These days he is particularly keen on technology. Top holdings include

Apple

(AAPL) - Get Report

and

Google

(GOOG) - Get Report

. Both companies report strong sales and earnings gains. While Google shares suffered a correction recently, the long-term trend remains up, according to Bacarella.

Another holding is

Chipotle Mexican Grill

(CMG) - Get Report

, a restaurant chain. The stock has been rocketing up for much of the past year. Bacarella thinks that the good news will continue because the company has been beating Wall Street earnings expectations.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.