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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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