Dear Dagen: How to Spot a Momentum Fund

Nowadays, any tech fund is a momentum fund. But some managers pursue the strategy no matter what sector is in favor.
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The investment world has a forbidden M word.

It's not margin call, market timing or even Milken.

It's momentum.

The almost pejorative term evokes images of crazed, risky, emotional investing. Mutual fund managers usually aren't willing to define themselves by that word.

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The label subtly suggests that a manager isn't following a quantifiable approach and is just blindly chasing stocks with the greatest price appreciation. The momentum crowd often gets blamed by other money managers and investors for running up stock prices in popular segments of the market.

By nature, momentum stocks are the hottest, most volatile names in the market. The price of a momentum stock can move up so rapidly that the underlying valuation of a company cannot keep up. With that lack of support, the stock can easily suffer a sudden, dramatic collapse in price.

"You have a lot of people playing the game at the moment," says Ed Larsen, chief equity officer at

AIM Funds

in Houston -- a firm known for its earnings momentum strategy. "If some exogenous shock hits the system, you can see enormous correction. All momentum players, whether it's price momentum or earnings momentum, want out at the same time."

With the

Nasdaq 100

up more than 35% since mid-October and 75% for the year, almost any fund with a heavy concentration in technology has become a momentum fund by default. Tech funds are de facto momentum funds, at the moment. For 1999, the average science and technology fund is up 94% through last Thursday, according to

Lipper

. But that doesn't mean tech managers necessarily pursue momentum strategies.

However, some firms and funds do actively practice momentum investing whether it's in vogue or not.

But how does an investor find out if a fund manager is a true momentum player?

Investors can look for a few key traits in a manager or a fund that are obvious giveaways. Also, some firms are recognized momentum shops --

Pilgrim Baxter

is one. AIM and

American Century

are two more.

Nicholas-Applegate

, which subadvises some

Pilgrim

funds, and

Turner Investment Partners

also are considered momentum shops.

Generally, momentum (mo for short) investors look for stocks that have accelerating earnings and steady price appreciation. By some definitions, a stock may have momentum if the company is consistently beating analyst estimates.

The basic philosophy of momentum investing is to get into a rising stock ahead of the crowd and to get out before the stock loses steam. "Mutual funds on average tend to be momentum investors because they tend to buy winners and sell off losers," says Tobias Moskowitz, assistant professor at the

University of Chicago

Graduate School of Business.

However, some characteristics do separate the momentum investor from the average growth manager.

First, managers of this ilk often use quantitative, mathematical models. These managers very often don't care about a company's fundamentals -- its products and management, for example. They aren't going to visit that winery in Northern California to see how the grape crop looks.

Second, these investors will usually sell on a negative event: an earnings warning, a product delay, a sudden management change. If you see a manager holding on to a stock after a disappointment, he's probably not a momentum investor, unless the stock's a short. If you hear a manager talking about buying on the dips, his style probably doesn't fall into the mo camp.

Funds of this type might very well have the word "aggressive" in the name or favor small- and mid-cap stocks. Momentum strategies will often favor smaller companies, as they can have more growth potential than a well-established large-cap name.

Momentum funds tend to have high turnover -- a measure of how often a manager is buying and selling stocks -- that runs into the triple digits. The average equity fund has turnover of 87%. By comparison,

(TSCEX)

Turner Small Cap Growth, a momentum fund that is closed to new investors, sports an annual turnover rate of 168%, according to

Morningstar

.

Also, "momentum tends to be heavily concentrated in certain sectors," says Moskowitz. "Big sector momentum, that drives a lot of strategies." These days, the momentum is in areas like wireless and networking stocks.

Qualcomm

(QCOM) - Get Report

, the king

daddy of all mo stocks, is up more than 1,400% this year.

Technical definitions aside, not all momentum strategies are alike. A manager can pursue a momentum strategy without blindly chasing rising prices. For example, AIM is widely recognized as a momentum player for its bottom-up, quantitative approach that focuses on earnings acceleration and steady earnings growth. All of the firm's growth funds follow some variation of this strategy. (The firm also has funds that follow value and growth-at-a-reasonable-price strategies.)

"We are not just chasing price," says Larsen. "We do try and get behind the numbers before we make decisions about a company. ... We do pay primary attention to earnings."

This approach has propelled some of the firm's funds to spectacular returns this year.

(ASCOX)

AIM Small Cap Opportunities, as one example, has run up 72.1%. Alas, this fund and another,

(GTSAX) - Get Report

AIM Small Cap Growth, have been closed to new investors for about a month.

American Century's strategy, used across its growth fund lineup, focuses on earnings and revenue acceleration. But "we peel the onion back a bit further," says spokesman Matt Egenes. "We do some fundamental analysis to turn over the drivers of earnings and revenue acceleration. ... I would draw the distinction between us and a momentum investor.

We are doing fundamental analysis and rolling up our sleeves."

Nevertheless, the firm's style shows in returns that can make wild swings.. The

(TWNOX)

New Opportunities fund is up 111% this year, and

(TWGTX) - Get Report

Giftrust is up 68.9% after years of dismal performance.

Giftrust is a prime example of what can happen when momentum turns sour. Last year, the fund was down 13.1%. In 1997, it fell 1.2%.

When the market's bias toward momentum fades, these stocks can come crashing down.

And no investor is ever prepared for that pain.

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deardagen@thestreet.com, and please include your full name.

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