Active Momentum Funds: Investment Strategies and How They Work

For years, investors have followed the basic principle of buying low and selling high. However, there is another approach that takes a different path: momentum investing. This strategy focuses on buying securities that are already showing strong upward trends and selling them when that strength starts to fade.

Momentum investing involves identifying and potentially capitalising on existing market trends. It works on the principle that assets performing relatively well in recent periods may continue to do so for some time. While this approach offers potential opportunities for quicker value appreciation during rising markets, it also carries significant market timing risk.

Mutual funds that invest in stocks demonstrating relatively stronger performance in the market are called momentum funds. This article explains the concept of momentum investing, how these funds operate, and what investors should keep in mind before considering them.

Table of contents

• What is a momentum fund
• Understanding the mechanics of momentum funds
• How momentum analysis influences investment decisions
• Key considerations for investing in momentum funds

What is a momentum fund

A momentum fund is a type of mutual fund that invests in stocks or assets that have shown relatively strong performance in terms of price or earnings trends. Instead of seeking undervalued opportunities, it focuses on securities showing upward momentum based on quantitative indicators.

These funds may offer the potential for returns if the upward trend continues, but they also carry high market risk if the trend reverses. Many such funds use proprietary momentum scores or follow momentum-based indices.

Momentum funds can follow either active or passive strategies.

• In active momentum investing, fund managers study price movements, trends, and other indicators to decide when to buy or sell holdings.
• In passive momentum investing, the portfolio mirrors a factor-based index that automatically selects securities according to predefined momentum factors.

Read Also: Value Investing vs Momentum Investing: Key Differences

Understanding the mechanics of momentum funds

Different fund houses and managers may follow different processes based on their strategies and outlook. However, the process may involve:

• Identifying strong performers: Fund managers track stocks that display a consistent upward price trend using technical indicators and momentum-based analysis.
• Buying the stock: Once a stock shows sustained upward movement supported by strong market momentum, the fund may add it to the portfolio, anticipating that the trend may continue for some time.
• Staying invested during gains: The fund may continue to hold such stocks as long as the positive momentum persists and price performance remains relatively steady.
• Exiting when momentum weakens: When the upward trend begins to slow down or reverse, the fund may sell the stock to book gains and reallocate capital to other securities showing stronger momentum indicators. However, such reallocations may carry their own risks.

How momentum analysis influences investment decisions

Momentum factors generally include aspects such as stock price movement, company revenue trends, and earnings growth.

Many momentum-based passive funds track specialised momentum indices. These indices typically review the past one-year performance of stocks and assign each a momentum score. This score is determined not only by past returns but also by factors such as company size, valuation, and quality indicators.

As a result, momentum funds consider both recent performance trends and selected company fundamentals when building their portfolios. Some also rely on technical indicators, such as price movements crossing previous highs, to identify potential opportunities.

Overall, momentum investing places significant weight on past performance, with the understanding that securities showing strong recent trends may continue their upward movement for some time. However, it is important to note that this relationship does not always hold true, as market behaviour can change rapidly.

Past performance may or may not be sustained in future

Momentum funds may offer potential gains during rising markets, but they also carry relatively high risk due to their sensitivity to market trends. In periods of volatility or declining markets, their performance may fluctuate sharply. Investors should carefully consider whether these funds align with their risk tolerance and investment objectives

Key considerations for investing in momentum funds

• Relatively high volatility and market fluctuations

Momentum funds may experience relatively high volatility since they follow stocks and assets that move rapidly. Prices can rise quickly during bullish phases but may also fall sharply during corrections or changes in sentiment. Investors considering such funds should be comfortable with short-term fluctuations.

• Weak performance in sideways or bear markets

Momentum strategies tend to perform better in strongly trending markets. During sideways or declining markets, identifying consistent upward trends becomes difficult, leading to potential underperformance.

• Frequent buying and selling leads to higher costs

Active momentum strategies require frequent rebalancing to stay aligned with market movements. This results in higher portfolio turnover and transaction costs, which may increase the fund’s expense ratio and impact overall returns.

• Requires continuous monitoring and timing discipline

Momentum investing demands ongoing evaluation of market data and trends. Since timing plays a crucial role, the expertise of the fund manager plays a significant role.

Read Also: All You Need to Know About Momentum Investing

Conclusion

Active momentum investing seeks to potentially benefit from prevailing market trends rather than forecasting future performance. It operates on the idea that securities showing strong recent performance may continue to do so for some time. However, this strategy also involves higher risk due to its dependence on market direction and timing. Investors with a relatively high risk appetite who understand market-linked fluctuations may consider exploring momentum funds as part of a diversified portfolio, after evaluating whether the strategy aligns with their investment goals. Investors should note that momentum funds may experience significant capital erosion during market reversals.

FAQs

What are the main risks associated with investing in a momentum fund?

Momentum funds carry relatively high volatility and may experience sharp reversals when market sentiment changes. They are also affected by high portfolio turnover, trading costs, and potential underperformance during bear markets.

Are momentum funds typically active or passive, and how does that affect them?

Momentum funds can follow both active and passive strategies. Active funds rely on fund managers to make decisions based on market signals, while passive funds track indices following momentum rules. Active funds may respond faster to changes, whereas passive ones adhere to predefined rules.

Can momentum funds be structured as ETFs or mutual funds?

Yes. Momentum investing strategies may be offered in both mutual fund and exchange-traded fund (ETF) formats, depending on the structure and investment objective of the scheme.

Why must investors closely monitor momentum funds?

Momentum trends can shift rapidly with market phases. Regular monitoring helps investors ensure the strategy remains aligned with their objectives and risk tolerance.

How reliable is past performance as a predictor of future returns in the context of momentum investing?

Past performance may or may not be sustained in future. Momentum strategies rely on recent performance trends which may reverse suddenly, potentially resulting in significant losses. These trends can change rapidly due to shifts in broader market conditions, investor sentiment, or economic factors. Investors should carefully consider their risk tolerance before investing in momentum-based products.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

The content herein has been prepared on the basis of publicly available information believed to be reliable. However, Bajaj Finserv Asset Management Ltd. does not guarantee the accuracy of such information, assure its completeness or warrant such information will not be changed.The tax information (if any) in this article is based on current laws and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.