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The Momentum Fund Phenomenon

A peculiar vulnerability of investors to chasing momentum can be strategically, perhaps uniquely, channelled

It’s now a good six months since the stock markets turned up decisively. The Nifty and the Sensex hit their bottom on March 9 and since then the markets have surged dramatically. As always, it started with the large-caps and then spread quickly to mid-caps, followed by a set of momentum stocks, some new and others the usual suspects. Naturally, there’s no shortage of mutual funds which have been able to exploit this and record tremendous gains for their investors. Over the last six months, as many as 120 out of 260 equity mutual funds have recorded gains of over a 100 per cent with a small leading pack of about 40 funds gaining in the region of 120 per cent and more.

However, the toppers list is dominated by funds that were at the very bottom of the pack when the markets were falling. Which are also the same funds that had risen most steeply when the markets were surging in 2006 and 2007. There’s a pattern here and while this pattern may not occur commonly in mutual funds, it does seem to have become the specialty of some funds. As any stock trader would realise, this pattern also occurs commonly in the investment track records of many individual traders. They follow the momentum stocks. When the going is good they make loads of money. And if they aren’t disciplined about setting, resetting and obeying stop-loss limits, then they lose loads of money, when the wind goes out of the markets’ sails.

By any conventional measure, this type of fund should be avoided. The whole point of investing in a mutual fund is to add a measure of long-term focus to your investments. A mutual fund investment manager is supposed to be as much bothered about losing less in the downward phase than he should be about gaining more in the upward phase. However, human nature being what it is, I have no doubt that some investors are going to follow recent hot performances and once again get into these high-risk funds. Inevitably, the cycle will repeat itself. An 80 per cent loss (as such funds had) followed by a 150 per cent increase still leaves the investor with just 40 paise out of every rupee that he invested.

The solution for the fascination that hot performances hold for some of us could be to treat these funds like momentum stocks. You’d like to chase momentum, hopefully with only a small part of your money. A certain type of fund manager seems to be an expert at doing that. So, instead of identifying and tracking momentum stocks yourself, why not think of these funds as momentum funds? This goes against all the good sense that I’ve been writing for years, but it’s probably a suitable solution for a peculiar behavioural problem.

The trick is to really treat these fund investments as momentum stocks and set stop-loss triggers. Invest (or perhaps ‘stake’ is the better word) your money and set a stop-loss for 10 per cent. Every time the fund goes up by 10 per cent, reset your base for the stop-loss to the net asset value (NAV). It goes without saying that this strategy works only without entry loads, so you will have invest either directly or with a distributor who charges a very small fee.