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One of the first things that every investor learns is that chasing recent winners is a mug’s game. This is true – but the reality is more complicated than most of us realize.

Over the past few years, momentum strategies have become increasingly popular among the investing cognoscenti. These strategies invert the conventional wisdom. They deliberately set out to buy stocks that have recently shot skyward.

Why? Research shows that recent winners have a tendency to go on performing well, for a little while anyway. Chasing performance can actually work if you do it systematically and rigorously.

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Small wonder then that momentum strategies are attracting growing amounts of money. The problem, however, is that details matter.

Nicolas Rabener, managing director of FactorResearch, a market analytics firm in London, demonstrated some of the realities of the momentum approach in a recent study of what works for investors in U.S. mutual funds.

He looked at what would have happened to someone who overhauled their portfolio every month by dumping their past holdings and buying the top-performing 10 per cent of equity mutual funds over the preceding 12 months. This seemingly crazy strategy – frenetically chasing top performers and holding many funds for only 30 days or so – is the antithesis of what most of us would regard as sensible investing.

But from 2000 to 2018, it would have worked splendidly, at least on paper. “We found the best-performing funds beat an equal-weight index of all equity mutual funds as well as the worst-performing funds by a handsome margin,” Mr. Rabener writes. “Put another way: Performance chasing works.”

So should you immediately start shaking up your portfolio every month? Probably not. As Mr. Rabener notes, the results ignore the transaction costs of buying and selling funds. “As a consequence, these results are more theoretical than practical.”

Modifying the strategy to reduce transaction costs doesn’t help. For instance, if, instead of overhauling your portfolio once a month, you did it only once a year, your results would fade. Buying top performers and holding them for 12 months yielded no better results in Mr. Rabener’s study than buying the worst performers and holding them for the same period.

Neither did it help to take a longer view. If you had based your selection of funds on their performance over the past three years, instead of just 12 months, buying top performers would have yielded dismal results. Whether you held them for one year or three years, the payoff from these longer-term winners lagged behind what you would have achieved by buying the worst performers.

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“These results suggest that mutual fund chasing deserves its bad reputation,” Mr. Rabener writes.

His conclusions point out both the promise and pitfalls of many of today’s momentum strategies. It’s true that momentum works in situations where you can implement a strict strategy and rebalance your portfolio frequently at low cost. But it’s a precarious victory. You are essentially betting on your ability to harvest the short-lived tendency of hot funds or stocks to keep on rising.

A more robust approach bets on the tendency of poorly performing securities to pick up their game. In market jargon, losers often revert to the mean, or average, of their peers.

In Mr. Rabener’s study, the best-performing strategy of all was the quick-twitch approach of overhauling your portfolio every month and buying recent winners. But nearly as good, from a risk-return perspective, was the slow, contrarian approach of buying the funds that had performed worst over the past three years and patiently holding them for the next three years, waiting for a rebound.

Both the momentum strategy and the mean-reversion strategy would have thumped the index. However, once you factor in the lower transaction costs of the mean-reversion approach, it seems likely that betting on losers, rather than winners, is likely to lead to better results in practice.

“As a rule, performance chasing is best avoided,” Mr. Rabener writes. “Our analysis indicates that investors would be better off betting on mean-reversion.”

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-- Ian McGugan, The Globe and Mail

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Stocks to ponder

Extendicare Inc. This 5.7 per cent yielding stock provides reliable income – but limited growth potential. Caring for seniors is not an exciting business, but it is well-positioned demographically. As the population ages, more people need assisted support, either in retirement residences or in their own homes. One of the Canadian leaders in this field is Extendicare Inc., which has been providing these services for more than 50 years. Gordon Pape recommend it for investors who are looking for above-average cash flow and are not overly concerned about capital gains (for subscribers).

People Corp. This Winnipeg-based employment services stock is in a multi-year uptrend, closing at a record high on Wednesday. This small-cap growth stock is covered by six analysts with a unanimous buy recommendation. Analysts are forecasting over 24 per cent top line growth for the company over the next fiscal year. Jennifer Dowty examines the stock. (for subscribers)

Archer Daniels Midland Co. Sometimes investment opportunities appear in the strangest places. For example: yeast. And this U.S.-listed stock just may be the stock to play this investment opportunity. Gordon Pape explains. (for subscribers)

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Bank of Nova Scotia After a stunning run of acquisitions, Bank of Nova Scotia is feeling the heat. Shares of Canada’s third-largest lender are suffering relative to rival Big Six banks, and the pressure is on management to prove its recent spate of deals was worth it, Tim Kiladze examines the stock. (for subscribers)

The Rundown

Three Canadian stocks to buy amid emerging market downturn

Emerging markets are in turmoil, and Canadian stocks have been caught in the downturn. But there’s a buying opportunity here for investors who want exposure to a rebound but don’t like the idea of betting on Turkey and Argentina, David Berman writes. Three Canadian companies stand out for their involvement in emerging markets: Bank of Nova Scotia, Brookfield Infrastructure Partners LP and Hudbay Minerals Inc. All three stocks have tumbled this year, shadowing a 21-per-cent decline in the MSCI Emerging Markets Index since late January. When emerging markets recover, these domestic stocks should regain their former glory. (For subscribers)

The dividend-paying stocks with momentum on their side

John Heinzl looks at three dividend-paying stocks that have momentum on their side. Their yields vary widely, but all three are on the buy lists of many analysts, who see further gains ahead. (For subscribers)

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TD to revamp discount brokerage arm

Toronto-Dominion Bank is partnering with a U.S. financial technology startup to revamp its online trading platform for retail investors as well as launch a robo-advisory service that will house its own proprietary exchange-traded funds. Clare O’Hara has all the details.

Picking dividend growers? Here are some suggestions

Dividend investors seek succulent returns from stocks offering high yields and strong dividend growth. But it’s possible to get too much of a good thing when looking for both qualities simultaneously. Norman Rothery dives in to see what combination works best when looking at Canada’s dividend stocks – is the highest yielding stock the best or the one growing its dividends? (For subscribers)

Number Crunchers (for subscribers)

The key to high-quality REITs with sustainable payouts? Diversification

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Five companies that aren’t likely to suffer if NAFTA went away

Ask Globe Investor

Question: I have a bearish outlook on global equity market especially after President Trump has imposed tariffs on all the U.S. trading partners. Below are my questions:

1. What is your opinion on Hive Shares? Since last year I have lost more than 75 per cent of its value.

2. I have around $5,000 to invest and I would expect to get at least 7 per cent annual return on it. Where and what can I invest in?

Answer: I assume you are referring to Hive Blockchain Technologies, which trades on the Toronto Venture Exchange under the symbol HIVE. I have never recommended this security and a look at its chart shows it has been a very bad investment. It has dropped from a high of $6.75 last November to around $0.80 as of the time of writing.

The company website describes it as follows: "HIVE is strategically partnered with Genesis Mining Ltd., the world's largest cloud mining company, to build the next generation of blockchain infrastructure. HIVE currently operates a total of four facilities (two in Iceland and two in Sweden) and are currently working on an additional two facilities in Sweden. Our facilities are capable of mining cryptocurrencies, like Ethereum, around the clock and will add our first Bitcoin mining facility by September 2018."

This description tells us this is a highly speculative stock that operates in a fledgling and uncertain market. Perhaps it some point it will make a breakthrough and the stock will move higher, but it is not the type of security I would ever recommend.

In regard to your second question, there are many securities that have the potential of giving you a 7 per cent return. The question is now much risk you want to take. You won’t get 7 per cent from a low-risk investment like GICs or government bonds. So, you need to look at stocks, ETFs, or mutual funds. I have offered many recommendations about securities that could generate returns or 7 per cent or more, but all come with some degree of risk. Right now, I would look at stocks or ETFs that focus on U.S. healthcare or technology companies.

-- Gordon Pape

Do you have a question for Globe Investor? Send it our way via this form. Questions and answers will be edited for length.

What’s up in the days ahead

Ian McGugan looks at the returns from major asset classes since the financial crisis 10 years ago - and reaches some interesting conclusions.

Click here to see the Globe Investor earnings and economic news calendar.

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Compiled by Gillian Livingston and Darcy Keith

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