The winning record of Rydex Sector Rotation shows that even a simple investing strategy can work. By Steven Goldberg, Contributing Columnist January 15, 2008 If you care even the slightest about value, chances are good that you hold momentum investing in utter disdain. Momentum players, in a nutshell, buy something that has gone up with the notion that it will keep going up. Sounds stupid, right? The fact is momentum strategies work. Not all the time, but enough of the time to be taken seriously. That's the conclusion Mark Hulbert, editor of the Hulbert Financial Digest, has come to after tracking investment newsletters since 1980. For example, NoLoad Fund X has chalked up outstanding returns with a system that requires clients to constantly switch into top-performing funds. And Value Line Investment Survey, which includes momentum elements in its timeliness rankings of individual stocks, has beaten the stock market over the nearly three decades since Hulbert went into business. Momentum also has been a winner for Rydex Sector Rotation fund since inception in mid-2002. Over the past five years through January 10, the fund (symbol RYSRX) has returned 15% annualized -- an average of nearly four percentage points per year better than Standard & Poor's 500-stock index. The fund ranks in the top 7% among large-company blend funds for that period, according to Morningstar. Advertisement The fund used an incredibly simple approach to produce those fine returns. Lead manager Adrian Bachman and colleagues examine the performance of the 67 industries measured by Standard & Poor's. They identify the six top-performing industries over the past three months and 12 months-that can give them a total of up to 12 industries to invest in. When industries are leaders over both time periods, they get a double weighting in the fund. The next step: They buy stocks that essentially perform in line with those industries. "We attempt to replicate those industries as best we can," Bachman says. "We don't buy all the stocks; there's no need to buy 120 banks." When an industry falls out of the top 20% oin price momentum, a new hot sector replaces it. The fund, not surprisingly, does lots of trading. Advertisement Turnover last year was 373%, suggesting the fund holds stocks between three and four months, on average. Rapid trading tends to result in lots of distributions, so this is probably a fund to hold in a tax-deferred account-although it hasn't made big capital-gains payouts so far. The S&P industry categories provide a universe of 2,000 stocks. A healthy percentage of those are based in foreign countries, so the fund invests in them through American Depositary Receipts (ADRs), which trade on U.S. exchanges. ADRs currently make up about 20% of the fund. However, the fund owns nothing in three of the market's broad sectors: financials, health care and technology. Among narrower industry weightings, 17% of the fund is in wireless telecom, and 9% each is in chemicals, construction and engineering, electrical equipment and metals and mining. All are beneficiaries of growth in emerging markets. Rydex has about 8% apiece in each of these industries: beverages; electric utilities; tobacco; oil and gas; energy equipment and services; and Internet and catalog retail. Because it invests in different industries, the fund migrates between growth and value. Because growth has been hot recently, the fund currently looks like a growth fund. Bachman says 60% to 70% of the fund is kept in stocks of large companies. The remainder is in small and midsize companies. Advertisement The fund works best, Bachman notes, in periods when industries have long stretches of strong performance -- as energy and industrial materials have had the last several years. It suffers in periods when industry leadership is changing rapidly. My biggest complaint with the fund is its expense ratio: 1.65%. That's an awful lot of money for a simple, albeit successful, investment discipline. After all, Rydex doesn't have to pay research analysts to circle the globe studying companies; all it does is buy stocks in the market's hottest industries. Why does momentum work? The behavioral scientists have the best answer. Imagine you own a stock. It's been doing well for a long time and then has one lousy quarter. Do you sell? Maybe, but more likely you hold on for another quarter or two or three to see if things will get better. Similarly, stock analysts tend to lower or raise estimates for a company in small increments -- rather than in big jumps. Advertisement We tend to be slow to adapt to new realities. So it takes time, sometimes lots of time, for most investors and analysts to act based on changes in a stock or an industry's outlook. And momentum investors make money during that time. I wouldn't base any investment decisions solely on momentum, but I think it's worth keeping in mind before you buy or sell a stock or a fund. First, of course, you want to make sure you're buying a stock or a portfolio that's attractive -- and attractively priced (value is something most momentum investors care little about). But it also can pay to make sure you're on the right side of the current trends. Now large-company growth stocks and foreign stocks are doing well. So long as the fundamentals continue to look good and the prices don't collapse, it might be wise to put a little extra money into those areas. Steven T. Goldberg (bio) is an investment adviser and freelance writer.