Momentum investing: What are momentum mutual funds?

Momentum funds are mutual funds that aim for relatively better returns by investing in companies demonstrating favourable current trends, particularly in earnings growth or stock price appreciation. The fund managers overseeing these portfolios actively seek out companies exhibiting positive momentum.

This article will help you understand these funds in-depth and the things you should consider while investing in them.

• Table of contents

1. Understanding large-cap funds
2. What are momentum mutual funds?
3. What are the benefits of momentum investing?
4. What are the cons of momentum investing?
5. Who should invest in momentum mutual funds?

What is momentum investing?

Momentum investing is an investment strategy that aims to capitalize on existing price trends. The core belief of this approach is that securities experiencing an upward price trajectory are likely to sustain this momentum, while those in decline are expected to continue their downward trend.

This strategy aims to capture sustained price movements to generate alpha, or excess returns, compared to traditional index-tracking strategies. This mainly involves identifying and investing in securities, sectors, or asset classes that have demonstrated recent strong performance with the expectation that this positive momentum will persist in the near to medium term.

However, unlike traditional buy-and-hold strategies, momentum investing necessitates wise timing, requiring investors to sell their holdings before the upward momentum subsides. This emphasis on market timing makes it a strategy that demands careful consideration and may not be suitable for all investor profiles.

Momentum trading employs various strategies to exploit stock momentum, including relative momentum, which compares the performance of securities within an asset class, and absolute momentum, which evaluates a stock's price action relative to its historical performance.

What are momentum mutual funds?

Momentum funds offer you exposure to momentum investment style. Momentum investing requires two key elements: a comprehensive understanding of financial markets and the ability to accurately anticipate future market movements. For many investors, these requirements can be daunting. However, momentum mutual funds offer a solution, allowing even novice investors to participate in momentum investing.

A momentum mutual fund is an equity scheme managed by a professional fund manager supported by a team of analysts. These investment experts meticulously select momentum stocks to construct a portfolio designed to capitalize on the ongoing success of companies experiencing upward price trends. The fund manager aims to benefit from further share price appreciation and strategically exit positions before the trend peaks.

While even the most seasoned fund manager may not consistently time the market perfectly, their market insights significantly enhance the probability of success compared to individual investors venturing into momentum stocks independently.

What are the benefits of momentum investing?

Momentum investing offers several potential advantages that can appeal to investors seeking to enhance portfolio performance.

• Potential for higher returns: Historically, momentum strategies have demonstrated the capacity to generate returns that surpass those of traditional index funds or actively managed funds, particularly during bullish market conditions.
• Exposure to broad market trends: Momentum investing enables investors to identify and benefit from secular market trends, which are not confined to a specific sector or market capitalization.
• Leveraging market volatility: Market volatility, an inherent characteristic of equity investing, can be harnessed to the advantage of momentum investors.
• Portfolio diversification: Momentum trends often encompass multiple sectors and stocks, providing investors with a natural avenue for diversification.
• Quantitative and objective approach: Momentum investing relies heavily on quantitative analysis, emphasizing observable price trends and performance metrics.
• Active trading opportunities: Momentum strategies often involve frequent buying and selling of stocks based on short-term price trends. This active trading approach allows investors to potentially exploit market inefficiencies and profit from short-term price movements.

What are the cons of momentum investing?

While momentum investing presents potential benefits, it is crucial to acknowledge its inherent drawbacks.

• Underperformance in bear markets: Momentum strategies have historically exhibited underperformance during bear markets, often experiencing significant drawdowns during market downturns.
• Higher volatility: Compared to other investment styles, such as value or low-volatility investing, momentum investing tends to exhibit higher volatility and may not be suitable for risk-averse investors.
• Frequent transactions and costs: Momentum investing typically involves frequent transactions as investors enter and exit positions based on evolving price trends. This can result in higher transaction costs and potential tax implications.
• Requires constant research and monitoring: Successful momentum investing necessitates continuous research and monitoring of market trends and individual stock performance.
• Sensitivity to market fluctuations: Momentum investing thrives in bullish market conditions but can be negatively impacted by sudden market fluctuations or prolonged downtrends.
• Necessity of market timing: The core principle of momentum investing, buying high and selling higher, relies heavily on accurate market timing. Consistently predicting market peaks and troughs is challenging, and mistimed entries or exits can significantly impact investment outcomes.

Who should invest in momentum mutual funds?

Momentum investing and momentum mutual funds may be suitable for investors possessing certain characteristics and investment objectives.

• Risk tolerance: Given the inherent volatility and potential for significant drawdowns during market downturns, momentum investing is most appropriate for investors with a higher risk tolerance. Individuals comfortable with market fluctuations and potential short-term losses may be better equipped to navigate the inherent risks of this strategy.
• Time commitment: Momentum investing demands ongoing monitoring and potential portfolio adjustments as market conditions evolve. Investors with the time and willingness to actively manage their investments may find this strategy more appealing.
• Long-term perspective: While momentum investing can generate attractive short-term gains, it is better suited as part of a diversified long-term investment strategy. This approach helps to mitigate the risks associated with market volatility and potential underperformance during specific periods.
• Understanding fund characteristics: Before investing in a momentum mutual fund, it is essential to thoroughly understand its investment philosophy, risk profile, and underlying holdings. Factors such as the universe of stocks, market capitalization focus, management style (active or passive), tax implications, and transaction costs should be carefully evaluated.
• Consideration of alternative strategies: For long-term investors, combining momentum investing with other strategies, such as low-volatility investing, can help to balance risks and potentially enhance overall portfolio performance.

Conclusion

Momentum investing, while potentially rewarding, is not a strategy to be undertaken lightly, particularly by those new to investing or seeking rapid gains. It demands a comprehensive understanding of its inherent risks and a commitment to a longer-term investment horizon.

Historically, the strategy has demonstrated its capacity to generate alpha or excess returns above the market benchmark over the long term. However, this potential for outperformance is accompanied by higher costs and heightened market risk, especially during periods of market decline.

As momentum funds continue to gain traction in India, their long-term performance consistency and their role within diversified portfolios will become increasingly evident. Investors considering momentum investing should conduct thorough research, carefully assess their risk tolerance, and consult with a financial advisor to determine if this strategy aligns with their overall investment objectives.

FAQs

How does a momentum fund work?

A momentum fund operates on the principle of identifying and capitalizing on prevailing market trends. The fund manager's primary objective is to pinpoint securities, sectors, or asset classes that have exhibited recent robust performance and are projected to sustain this upward trajectory in the foreseeable future.

This selection process typically involves a combination of quantitative and qualitative analysis, scrutinizing factors such as recent price movements, earnings growth, and relative strength compared to peers and benchmarks. The fund manager then constructs a portfolio comprising these high-momentum securities with the expectation that their prices will continue to appreciate. Once a security's upward momentum shows signs of waning or its price approaches a perceived peak the fund manager will strategically sell the holding to lock in gains.

What is an example of momentum investing?

This is a simplified illustration:

Imagine a technology sector experiencing a surge in investor interest due to breakthrough innovations and robust earnings growth. Within this sector, several companies have consistently outperformed their peers and the broader market over the past year, exhibiting strong upward price momentum.

A momentum investor, observing this trend, might invest in these high-performing technology stocks. If any of the stocks begin to show signs of weakening momentum or the overall technology sector experiences a downturn, the investor would promptly sell their holdings to mitigate impact on their gains and mitigate potential losses.

What is the difference between a momentum fund and a value fund?

Momentum funds prioritize stocks with robust recent growth, aiming to profit from further price increases regardless of the holding period. On the other hand, value funds focus on undervalued stocks, seeking long-term gains from their eventual appreciation of their intrinsic value.

What is the return of momentum fund?

An examination of the historical rolling returns of momentum-focused investment strategies reveals a compelling trend: the likelihood of experiencing negative returns diminishes significantly, approaching zero, over investment horizons of five years or longer. However, past performance is not a guarantee of future results. Market dynamics are inherently unpredictable, and momentum strategies, like all investment approaches, carry inherent risks.

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.