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 relatively strong trends and selling them when that strength starts to fade.
Momentum investing involves identifying and 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 may provide opportunities during strongly trending markets, it also carries significant market-timing and reversal risk.
Mutual fund schemes that invest in stocks demonstrating relatively stronger performance are commonly called momentum funds. This article explains the active momentum fund meaning, how active momentum funds operate and what investors should consider before investing.
Table of Contents
What is a momentum fund?
A momentum fund is a mutual fund scheme that invests in stocks or other permitted assets showing relatively strong price, earnings or business-performance trends. Instead of primarily seeking undervalued opportunities, it focuses on securities displaying momentum according to the scheme’s investment process.
These funds may benefit if the identified trend continues, but they can also experience sharp losses if that trend reverses. Fund houses may use proprietary momentum scores or follow a momentum-based index.
Momentum funds can follow active or passive strategies:
- In active momentum investing, fund managers use quantitative models, research and their judgement to decide which securities to buy, hold or sell.
- In passive momentum investing, the portfolio tracks an index that selects and weights securities according to predefined momentum rules.
An active momentum fund is therefore not restricted to automatically following an index. Its fund manager can interpret model output, assess liquidity and market conditions, and adjust the portfolio within the scheme’s stated investment mandate.
Key Takeaways
- Momentum funds invest in securities showing relatively strong recent performance, based on the expectation that the trend may continue.
- Active momentum funds rely on fund managers and proprietary models to evaluate momentum signals and select securities.
- Active management allows the portfolio to be adjusted when market leadership or momentum characteristics change.
- Momentum strategies can be volatile and may struggle when markets become range-bound or reverse sharply.
- Investors should consider their risk appetite, investment horizon and portfolio diversification before investing.
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 relatively strong price, earnings or business-performance trends using quantitative models and momentum analysis.
Selecting securities
Once a stock meets the fund’s momentum and other selection criteria, it may be added to the portfolio. The fund manager may also consider liquidity, valuation, business fundamentals and prevailing market conditions.
Staying invested while momentum continues
The fund may hold a security for as long as its momentum remains favourable and it continues to meet the scheme’s investment criteria.
Exiting when momentum weakens
When a trend slows, reverses or becomes weaker than that of another eligible security, the fund may sell the holding and reallocate the capital. Such changes do not assure that the fund will enter or exit at the most favourable time.
How momentum analysis influences investment decisions
Momentum analysis can include stock-price movements, earnings trends, revenue growth, return ratios and other quantitative or qualitative factors. The precise combination depends on the scheme’s investment strategy.
Passive momentum indices follow a specified methodology. For example, the Nifty200 Momentum 30 Index calculates its normalised momentum score using six-month and 12-month price returns adjusted for daily price-return volatility. Stock weights are based on the momentum score and free-float market capitalisation.
Active momentum funds can use a broader proprietary process. The fund manager may evaluate model-generated rankings alongside liquidity, company fundamentals, valuations and market conditions before selecting securities or determining portfolio weights.
Momentum investing places considerable weight on recent performance trends, based on the view that relatively strong securities may continue to outperform for some time. This relationship does not always continue, and market leadership can change rapidly.
Past performance may or may not be sustained in future.
Source: NSE Indices, Nifty200 Momentum 30 Index white paper.
Why investors may consider actively managed momentum funds
Active management adds research and fund-manager judgement to the momentum-selection process:
Active stock selection
Fund managers may evaluate momentum indicators together with business fundamentals, valuations, liquidity and market conditions while selecting stocks.
Portfolio adjustments
The portfolio may be rebalanced as momentum characteristics change, allowing the fund to respond to changes in market leadership.
Participation in established market trends
The strategy seeks to participate in securities that are already displaying relatively strong performance rather than relying entirely on forecasts of a future turnaround.
Diversification across securities
A momentum fund may invest across multiple stocks and sectors, reducing dependence on the performance of a single company. Its holdings can still become concentrated in sectors displaying stronger momentum.
Who may consider actively managed momentum funds?
Since active momentum funds invest primarily in equities and may change their holdings as market conditions develop, investors generally need a high risk appetite and the ability to remain invested through periods of volatility.
They may be considered by investors who:
Have a long-term investment horizon
Equity-oriented momentum strategies can experience considerable variation across market cycles. A longer horizon may give investors more time to remain invested through weaker phases.
Understand momentum-based investing
Investors should recognise that recent price or earnings trends may not continue. Momentum stocks can experience sharp reversals when market sentiment changes.
Can tolerate relatively high volatility
The value of the investment may fluctuate significantly because of equity-market movements, changing momentum signals and portfolio rebalancing.
Prefer active portfolio management
Investors who want a fund manager to interpret quantitative signals, research stocks and adjust the portfolio may consider an active approach instead of a predetermined momentum index.
Already have a diversified portfolio
Momentum funds may be considered as one component of a diversified portfolio rather than the investor’s only equity holding.
Key considerations for investing in momentum funds
The characteristics that make momentum strategies responsive to market trends can also create distinct risks:
Relatively high volatility
Momentum funds may invest in stocks whose prices are moving rapidly. These securities can rise during favourable phases but may also fall sharply during corrections or changes in sentiment.
Weak performance in sideways or declining markets
Momentum strategies generally work more effectively when clear trends persist. Range-bound markets can produce frequent changes in signals, while sudden reversals may affect stocks that had previously performed well.
Higher portfolio turnover
Active momentum strategies may require frequent buying and selling to remain aligned with changing signals. Higher turnover can increase transaction costs within the portfolio and affect returns.
A higher portfolio turnover does not automatically mean that a scheme will have a higher stated expense ratio. The expense ratio and portfolio turnover ratio should be assessed separately.
Timing and model risk
A momentum model may identify a trend after part of the price movement has already occurred. It may also retain a security for too long or exit before the trend resumes.
Sector and style concentration
If a particular sector or market-cap segment is displaying strong momentum, the portfolio may develop a higher allocation to that area. This can increase sensitivity to a reversal within that part of the market.
Dependence on the investment process
Performance depends on how effectively the fund’s model identifies momentum and how the fund manager interprets its output. Different active momentum funds can therefore hold different portfolios and produce different results.
How to evaluate an active momentum fund
The scheme name alone does not explain how its momentum strategy is implemented. Before investing, investors can review:
- The investment objective and momentum-selection process described in the Scheme Information Document
- The scheme’s Risk-o-meter and benchmark
- The range of market capitalisations and sectors in which the fund can invest
- Portfolio concentration and changes in sector exposure
- Portfolio turnover, expense ratio and exit load
- The fund manager’s approach to liquidity, risk control and changing momentum signals
- Performance across rising, declining and range-bound markets, where an adequate track record is available
Fund comparisons should use similar periods, benchmarks and plan types. Short-term outperformance alone does not establish that one strategy will remain more suitable.
Conclusion
Active momentum investing seeks to benefit from prevailing market trends rather than forecast which securities may recover in the future. It operates on the idea that securities showing relatively strong recent performance may continue to do so for some time.
The strategy also involves higher risk because of its dependence on market direction, security selection and timing. Investors with a high-risk appetite who understand market-linked fluctuations may consider momentum funds as part of a diversified portfolio after assessing the scheme’s investment process, costs and suitability for their goals.
FAQs
What are the main risks associated with investing in a momentum fund?
Momentum funds can experience sharp reversals, high volatility and weaker performance in sideways or declining markets. Active strategies may also carry portfolio-turnover, timing, concentration and model risks.
What is the difference between active and passive momentum funds?
An active momentum fund allows the fund manager to interpret quantitative signals and make portfolio decisions. A passive momentum fund tracks an index and follows its predefined selection, weighting and rebalancing rules.
Can momentum strategies be offered through ETFs or mutual funds?
Yes. A momentum strategy may be offered through an actively managed mutual fund, an index fund or an exchange-traded fund, subject to the investment objective and structure of the scheme.
How often do active momentum funds change their holdings?
There is no standard rebalancing frequency for every active momentum fund. Holdings may change whenever securities no longer meet the scheme’s momentum criteria or stronger opportunities are identified, subject to the fund’s investment process.
How reliable is past performance for evaluating momentum funds?
Past performance does not predict future returns. Momentum strategies rely partly on trends that can reverse because of changing market conditions, earnings expectations or investor sentiment.
Are active momentum funds diversified?
They may hold securities across several companies and sectors, but their portfolios can become concentrated in areas displaying stronger momentum. Investors should examine the latest portfolio rather than assume broad diversification.
Can an investor use an SIP to invest in an active momentum fund?
An SIP may be available if the scheme offers that facility. It spreads investments across different dates but does not remove the risks associated with momentum investing or equity-market fluctuations.
How can you invest in actively managed momentum funds?
Investors can invest through the relevant AMC website, a mutual fund platform or an authorised distributor after completing the applicable KYC requirements. The Scheme Information Document should be reviewed before investing.
How should investors compare active momentum funds?
Investors can compare their investment processes, benchmarks, portfolios, turnover ratios, expense ratios, risk levels and performance across different market conditions. Comparisons should use the same plan type and a consistent period.
