Understanding Momentum Funds: How Momentum Investing Works

Momentum investing follows stock price trends, aiming to buy strong-performing stocks and sell them higher. It offers potential alpha, but investors must manage risks through SIPs and trend-following strategies.

Momentum investing is a strategy that focuses on stocks that have shown strong price trends over a specific period. Unlike traditional investing approaches that emphasize buying undervalued stocks, momentum investing follows the principle of "buy high, sell higher." This strategy has gained popularity due to its potential to generate superior returns compared to conventional investment styles.

What Are Smart Beta Funds?

Smart beta funds blend passive and active investing strategies by tracking factor-based indices. These indices are constructed based on historical data-driven investment factors that have influenced portfolio returns and risks. The key factors include Momentum, Low Volatility, Beta, Alpha, Value, Quality, and dividend Yield.

Factor-based indices are classified into:

• Single-Factor Indices: These indices select stocks based on a single investment factor. For instance, the Nifty 500 Momentum 50 Index comprises the top 50 companies with the highest momentum scores based on 6- and 12-month price returns, adjusted for volatility.
• Multi-Factor Indices: These indices use multiple factors to select stocks. An example is the Nifty Alpha Low Volatility 30 Index, which combines Alpha and Low Volatility to track 30 stocks from the Nifty 100 and Nifty Midcap 50 indices.

Smart beta funds provide the advantage of factor-based investing at relatively lower costs compared to actively managed funds while aiming to generate alpha.

Why Factor-Based Investing Is Gaining Popularity

Factor-based indices have demonstrated the ability to outperform broad market indices over extended investment horizons. Historical data suggests that factor strategies like momentum have delivered higher risk-adjusted returns in bullish markets, making them an attractive option for investors looking to enhance portfolio performance.

How Does Momentum Investing Work?

Momentum investing is based on the principle that stock trends persist. Stocks that have performed well in the recent past are likely to continue their upward movement, while underperforming stocks may continue their decline. The key aspects of momentum investing include:

• Stock Selection: Momentum strategies overweight stocks with strong upward price trends.
• Entry & Exit: Stocks are added once they exhibit strong momentum and exited when the trend reverses.
• Trend Following: Instead of predicting market tops or bottoms, the strategy identifies ongoing trends and participates accordingly.
• Risk Management: While momentum investing is often considered high-risk, trend-following methods help mitigate downturn risks by exiting declining stocks.

Why Momentum Investing Can Generate Alpha

Momentum strategies have demonstrated their ability to generate excess returns, known as alpha, over time. While the strategy underperforms in volatile or sideways markets, its ability to deliver superior gains during strong market trends makes it a valuable addition to an investment portfolio. Historical data indicates that the magnitude of outperformance in bullish markets often outweighs the underperformance during corrections, making it a compelling long-term strategy.

Wealth Creation Potential of Momentum Funds

The Nifty 500 Momentum 50 TRI Index has significantly outperformed the broader Nifty 500 TRI over long investment periods. The wealth generated through momentum investing showcases its potential for capital appreciation. The long-term performance data suggests that investors who remain invested in momentum funds for extended periods may experience substantial wealth accumulation.

Momentum Funds and Systematic Investment Plans (SIP)

Momentum stocks tend to be more volatile, making them suitable for investment through Systematic Investment Plans (SIPs). SIPs help investors benefit from Rupee Cost Averaging, mitigating the impact of short-term volatility. Historical data illustrates that a monthly SIP of Rs 10,000 in the Nifty 500 Momentum 50 TRI Index since its inception (approximately 20 years ago) would have grown a corpus of Rs 2.6 crores from a total investment of around Rs 24 lakhs.

Who Should Invest in Momentum Funds?

Momentum funds are best suited for:

• Investors seeking capital appreciation over long investment tenures.
• Investors looking to incorporate an aggressive strategy into their portfolio.
• Investors with a high-risk appetite.
• Investors with a long-term investment horizon (at least 5 years).

Before investing in momentum funds, investors should consult financial advisors to determine the suitability of these funds based on their risk profile and investment objectives.

Conclusion

Momentum investing follows a trend-based approach that capitalizes on stocks exhibiting strong price performance. While it is associated with higher risk, its ability to outperform in strong market trends makes it an appealing strategy for investors seeking long-term capital appreciation. By leveraging factor-based strategies such as momentum, investors can enhance their portfolio returns while managing risks through systematic investment methods like SIPs.

Disclaimer: The article is for informational purposes only and not investment advice.