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Mark Dampier: Why momentum investing via open-ended funds must stop

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When I began my career in financial services over 30 years ago, unit trust pricing was very different. Commentators today are determined to talk of high fees but they would have had a shock back then when nearly all unit trusts applied an initial charge of at least 5 per cent.

On top of this, a spread (the cost involved in buying a unit in a fund) would often be charged, so the actual initial cost of investing could reach 7 per cent or more.

This started to change as so-called fund supermarkets came to market and discounted much of the initial charge and their own commission from the individual fund groups, some of which was rebated to clients. They worked to negotiate lower fees and were instead ultimately paid renewal commission.

Fast forward to the present day and, while platforms now receive fees from clients rather than commission from fund groups, most unit trusts no longer apply an initial charge. The obvious benefit to investors is more of their money gets invested on day one. Annual management fees are also beginning to move downwards.

Generally speaking, all the news is good so far. However, on the other side of the coin is the rise of the momentum investor.

Momentum investing is a strategy whereby fund managers buy the shares of companies that have shown an upward trending price and hold onto them until this trend reverses. The strategy is often short term in nature but many investors are now also applying it to unit trusts, which have traditionally been viewed as long-term vehicles.

Statistics are now available whereby investors can find out which unit trusts are performing best over short periods of time. Some people are even beginning to collate this information in order to sell it to investors.

Advocates of the strategy say it is not possible to be caught out by a fund falling heavily in value, as investors would have already sold their position before it creates a significant loss and moved on to the next rising fund. In the past a high initial charge would have likely stopped this type of short-term trading. As most unit trusts no longer apply an initial charge, it appears the main barrier has been removed. What is more, most platforms do not charge a switching fee between funds.

So what is not to like? Well, plenty. Open-ended funds are not designed to see large and frequent inflows and outflows of money. It hardly helps a fund manager to have £5m come into their fund one day, only to see the entire sum disappear a few weeks or months later.

Nor can it be helpful to existing, genuine long-term investors. The problem with the strategy is it is not scalable: the more people that take part, the bigger the problem for fund managers, until eventually the whole thing will need to come to a halt.

I am also suspicious of the statistics provided as they do not take into account trading costs. With this type of strategy, many investors will trade at a similar time. When managers are faced with a large disposal, a fund group can charge a dilution levy or adjust the unit price downwards as a way of protecting existing investors. I am unsure whether these costs are included in the performance statistics I have seen.

In conclusion, this strategy involving short-term trading is not in the favour of genuinely long term investors. It is certainly not in the favour of fund managers who are left to contend with heavy flows in and out of their fund, most likely just at the wrong time.

If you insist on using this type of strategy you should confine it to closed-ended funds, which are far better short-term trading vehicles. Remember, some of us are genuine long-term investors.

Mark Dampier is head of research at Hargreaves Lansdown

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Comments

There are 2 comments at the moment, we would love to hear your opinion too.

  1. If someone is stupid enough to put £5 million into momentum investing they won’t have £5 million for very long. And hence the problem solves itself.

    Money goes in and out of open-ended funds on a constant basis, the assertion that there are enough tea-leaf readers with enough money to noticeably disrupt this needs more evidence than presented here.

  2. This is a particular problem with small cap funds. Investors can move in and out far more easily than a fund manager can deal in his portfolio at a sensible price. Under selling pressure from redemptions the most marketable stocks go first – reducing the liquidity of the portfolio that is left. ( Mark will remember Touche Remnant Small Companies which suffered acutely from this.) Limited issue funds with redemption restrictions are the answer – but advisers are nervous about using them it seems.

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