Managed Fund Survey: Grow with the flow

It's called momentum theory, the idea that all investors have to do is follow the big money. But can the herd instinct only work with bull markets? By Tony Lyons

No fund manager worth his salt will admit to being a momentum theorist. Yet in the last few years the behaviour of the stock market suggests that most have been investing on the basis of momentum.

In short, momentum theory says: "If others are buying into a company, they must know what they are doing, so join in."

The wave of money chasing finance, pharmaceuticals, telecommunications and technology shares can be explained by this simple theory.

These are the stocks that dominate the main indices, chased by index tracking funds. Other investors, seeing these shares going ever higher, have sold out of other shares to chase these companies.

It all sounds very much like following the herd. If fund managers see every one else buying shares in particular companies, they won't go far wrong if they join in. When it comes to review time by the fund's trustees, or when unit holders look at their reports, they will see their funds doing the same as everyone else.

"In America, where the market is very polarised and hedge funds are common, there are many momentum funds that own up to following this investment theory," says John Hatherly, of M&G. "The idea is what goes up will continue to go up. If it is the herd instinct, always remember that the herd is mighty powerful."

Stock market conditions since 1995 have backed up this theory. Big companies have attracted ever more money, their share prices continually rising despite the odd hiccup, while other shares have often languished in their wake. "The expensive has become more expensive, while cheap stock has become even cheaper," comments Mr Hatherly.

The only problem with the momentum view of investment is that it does not tell the investor when to sell. "In its purest form, it tells you that, if a share price is hitting new highs, you should buy," says Bob Yerbury, of Perpetual.

"This means that you have to be an active trader, continually buying on the way up. When the market in a company's shares turns, then it says you should sell all your holding. This is a recipe for big losses. The market these days can turn rapidly, and a share price can plummet quicker than you can place your sell order. Momentum theory is not a science, rather it is going with the fashionable trend until it's no longer fashionable."

Most fund managers in this country, while they cannot ignore trends, will claim that they invest for a particular reason, whether it's because of fundamental values or growth prospects, not because they are following the herd.

Opposed to the momentum view are what can be called contrarians. "These are prepared to own shares that are currently unpopular for one reason or another; they may not be performing at the moment, but they are so cheap that they will make money eventually," explains Bob Yerbury. "The only problem, if no one else ever sees that these shares are undervalued, then no matter how cheap they are, they still won't do anything."

Contrarian funds exist in large numbers. Any funds that invest in special situations or recovery stocks or those funds that specialise in small companies can be said to be in this camp. While normally high risk, they have been successful in past bull markets, although, during the current bull run, they have suffered.

However, if stock markets get over the current phase, where the top-performing funds are those that invest in the largest companies, or if a bear market arrives, contrarian funds or those that invest outside the Ftse stocks may return to prominence.