Value-oriented, return-to-the-mean investors have dominated North American stock markets in years past. Effectively, this is Warren Buffet’s strategy of buying low and selling high as a path to superior returns. But times have definitely changed.

The new mantra might be “buy high and sell higher,” as William O’Neil, publisher of Investor’s Business Daily has extolled. Furthermore, as Charles Gave, founding partner and chairman of Hong Kong-based Gavekal, asserts, the increasing dominance of passive investing, or indexing, is fuelling the ascendance of “mo-mo” (momentum) investing. With so many trillions blindly tracking benchmarks, the higher a member of the given index rises, the more money must go into it, causing big upside overshoots.

As a result, financial planners need to manage the risk to their clients’ portfolio of this excessive momentum investing. To demonstrate this risk further, consider that some index funds may be overweighted to high-priced stocks of successful companies. Although this may sound like a good strategy, the caution is that these funds use momentum strategies in which as the prices go higher, more money is invested in the higher-priced stocks held in the fund. Moreover, the majority of the capital tends to get allocated near the final stages of a rising trend in which valuations are the highest and the safety is smallest.

This concern will be even more pronounced in U.S. funds as their markets have risen dramatically since the 2008 market crash. This simply means that clients may have excellent performing index funds in their portfolios, but if these portfolios are overconstructed toward momentum investing, then losses will be greater than in a more balanced and weighted index fund when markets correct.

Here are a few examples to illustrate what can happen, as outlined in an EVA research newsletter on

First, there’s the example of Guggenheim Solar ETF, which trades on the New York Stock Exchange and is run by a U.S. money manager. The ETF had its largest position by far in Hanergy, a China-based solar company this past April. Hanergy was an early “beneficiary” of China’s stock bubble, and its stock rose by more than 600% over the preceding year. This made it the most valuable solar stock on the planet and forced indexers to weight it according. At its apex, Hanergy accounted for 12% of Guggenheim Solar ETF’s assets under management (AUM) before crashing by 50% in a few hours on May 20, causing its trading to be halted. Obviously, investors in this fund had their losses magnified by this overweighting to one high-performing stock.

Also consider a less extreme example: iShares Silver Trust. As silver rocketed to US$60 an ounce in 2011, in-flows of money hit the moon. Silver’s collapse to US$14 an ounce recently again highlights the risk of momentum investment strategies. If you had a buy-and-hold strategy for silver and bought the fund in 2010, when it traded close to US$14 an ounce, then you were even after the fund’s collapse. On the other hand, if you got caught up in this mania at the high point and didn’t sell in time, then your losses were greater when measured on a dollar-weighted basis, which is what investors actually realize from an investment vehicle. This was due to how much money flowed into the fund toward its peak.

So, how is momentum investing changing the overall fund market and the investment strategies for a client? According to Franklin Templeton Investments Corp., flows into passive funds were 15 times those into active funds in 2014. In addition, a report from PricewaterhouseCoopers LLP entitled Asset Management 2020: A Brave New World, it’s estimated that passive funds will gain a 22% share of global AUM by 2020. With trillions of dollars now blindly tracking index weightings, what goes up or down gets carried to absurd extremes, such as in the Hanergy example. This exaggerates the momentum investing effect clearly.

Based on these trends, here are some steps financial planners can follow to minimize the risk of momentum investing in their clients’ portfolios:

1. Ensure that indexing does not become the most influential strategy in clients’ portfolios as strange things may start happening, as depicted in the aforementioned examples.

2. Do your due diligence and ensure a recommended index fund is not overly constructed toward momentum investing as there are funds that are balanced and have more widely weighted stock positions.

3. Trends are trends. Advise clients that a little underperformance in the short-term vs riding the latest fad can lead to greater performance in the long run, such as during a full market cycle for disciplined investors.

Momentum investing is just a tool to ride a trend. Unless a financial planner or financial advisor is a perfect market timer, he or she may lead clients to live by the trend and, consequently, die by the trend on the downside of the market.