Understanding Momentum Investing: Strategy, Risks and Return Potential
Momentum investing is a strategy that involves investing in financial instruments that have shown a strong upward trend in recent periods. Such funds aim to capitalise on the upward trajectory of these stocks with the aim of optimising return potential.
In this article, we will explore how momentum investment differs from other mutual fund investment strategies as well as its benefits and risks.
- Table of contents
- How momentum funds differ from other mutual funds
- Investment strategy of momentum funds
- Riding on trends
- Benefits and risks of momentum investing
- FAQs
How momentum funds differ from other mutual funds
Momentum investing is premised on the assumption that the upward momentum of certain stocks is likely to be sustained in the near term. Thus, a momentum investment strategy focuses on identifying stocks that have shown strong price appreciation in recent periods.
Since these funds aim to ride this momentum, momentum investment returns and growth potential are usually higher, albeit at a higher associated risk. Many momentum funds in India are index funds, where the portfolio is designed to replicate an index such as Nifty200 Momentum 30 and Nifty Smallcap250 Momentum Quality 100. Fund managers may also incorporate a momentum investing strategy while designing their portfolio in other equity schemes.
Investment strategy of momentum funds
Momentum investment uses various techniques to identify stocks with strong momentum. These techniques include analyzing price charts, identifying trends, and using technical indicators such as moving averages, relative strength index (RSI), and momentum indicators (price momentum, earnings momentum).
For active momentum funds, the fund manager needs to create a portfolio with securities that have displayed positive price trends and then continuously monitor stock performance. The portfolio may need to be altered periodically to ensure that the stocks that have lost momentum are replaced with new ones that have shown a strong recent price performance.
Riding on trends
The momentum investment growth potential is based on the performance of the underlying assets. Momentum funds aim to capitalize on the growth potential of stocks by riding their upward trend and exiting when the securities reach their peak. This strategy can lead to relatively higher potential returns in the short or medium term when the market conditions are favorable – such as during a bull run – but at a very high level of associated risk because it relies on the momentum continuing.
Benefits and risks of momentum investing
Momentum funds offer several potential benefits to investors, including:
- Relatively higher return potential: Momentum funds have the potential to provide relatively higher returns than other mutual funds due to their focus on high-performing stocks.
- Diversification: Momentum funds can offer diversification benefits as they can invest in a broad array of different companies which have shown a recent price surge. They can form a part of a diversified portfolio that also has funds that are relatively more stable, to balance risk and potential reward.
- Reversal risk: Momentum funds are highly volatile compared to other mutual funds, as they invest in stocks that have shown rapid price appreciation. However, there is a high risk of a trend reversal. Markets are inherently unpredictable and asset prices that have exhibited strong recent momentum may suddenly plummet.
- Overvaluation risk: Herd investing may lead to prices may become detached from an asset’s underlying fundamentals, leading to bubbles. When such market bubbles burst, they can cause sharp corrections in asset values.
- High volatility: The stocks included in momentum funds can exhibit a strong momentum both towards the upside and the downside, leading to extreme swings in portfolio value. Investors must have a very high risk appetite to tide over such fluctuations.
Momentum funds carry certain risks, including:
Conclusion
Momentum funds offer a unique investment opportunity to investors with a high risk appetite who are seeking the potential for relatively higher returns. Momentum investing involves focusing on stocks that have shown strong upward price trends in the recent past and are expected to continue growing in the near term. However, it's important to understand the risks associated with momentum investing and to carefully consider whether this investment style is suitable for your investment goals and risk tolerance.
FAQs:
Are momentum funds suitable for all investors?
Momentum funds carry a very high level of risk. Hence, they may be considered by investors with high risk appetite as a small allocation in a diversified portfolio.
Can momentum funds guarantee high returns?
No investment can guarantee returns and momentum stocks can be unpredictable and volatile because they are heavily impacted by market conditions. In the right conditions, they can offer above-average returns but the various risks they are susceptible to include overvaluation, market timing risks and the risk of sudden or rapid price reversals.
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 purposes 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.