We’re all familiar with the concept of buying at a low price and then selling off at a higher price, as a strategy to make a profit.
But, unless you’ve been living under a rock, you’re aware of how the stock market has been rallying ever since the COVID-19-induced fall.
“The Nifty 50 fell to a low of 7,511 on March 24, 2020. Four years later, it is 3x from those levels.” — CNBC TV18 as of April 02, 2024
So, how does one invest in a market that seems to be going up and up?
The answer is they don’t! Instead, the investor aims to buy at a high price and sell at an even higher price. The focus is on capturing the momentum and riding the wave.
How? Let’s find out!
What is Momentum Investing?
Momentum investing is based on a simple concept.
It is a rule-based strategy in which the fund manager seeks to buy securities that are rising and sell them when they look to have peaked. The goal is to work with volatility by analysing the momentum of the securities.
However, investors should always consult their financial advisors before investing.
Think of the market as a continuous slope, with no top and no bottom. You’re simply joining along for a part of the ride, not the entire way.
Difference Between Momentum and Value Investing
Now, this approach is quite different from value investing, which seeks to identify undervalued assets. The latter considers many factors like historical price performance, volatility of returns, relative strength, liquidity etc. to name a few.
In momentum investing, however, you’re not focussing on the valuation of the asset at all. Instead, the focus is on recent price trends — i.e. the fund manager purchases those assets that have shown upward momentum and sells those that have underperformed. It’s more of a forward-looking approach.
Thus, we may assume that momentum investing focuses more on behavioural finance.
Behavioural finance studies how psychological influences affect the financial behaviour of individuals. It delves into why we act the way we do when it comes to investments.
One of the concepts studied in behavioural finance is the tendency for well-performing assets to attract more investor attention, potentially leading to further price increases.
Please keep in mind, however, that this can also lead to a herd mentality. When you start to make investment decisions based on what others around you are doing, it is very easy to lose sight of the fundamentals. Your investment decisions should be based on your risk preferences and goals. Please consult with an advisor before investing.
How Does It Work?
Imagine, for instance, that you’ve been tracking the performance of stocks which form part of the green energy sector in India. You’ve noticed that quite a few companies in this segment have really boomed in the past few months. You’re fairly optimistic that this growth is just the beginning, and there may be a strong rally in these stocks.
After all, the government is focussing more on green energy. Well, in all honesty, the whole world is, but that’s another story.
You expect that India will push aggressively to reach its target emission goals by 2030, and green energy will be the key to unlocking this.
FYI, these are some of India’s targets for 2030:
- Non-fossil fuel energy capacity of 500 GW
- Half of the energy requirements to be fulfilled by renewable sources
- Reduce carbon emissions by 1 billion tonnes
- Reduce carbon intensity below 45%
But the question is, how do you identify which particular stocks have momentum in their favour and the highest possibility of growing?
Luckily, you don’t have to.
This is where mutual fund managers come in. They are professionals who are equipped to analyse the markets on the basis of historical price performance, volatility of returns, relative strength, liquidity etc. to name a few. They have already read your mind and brought a possible solution for you — momentum mutual funds.
Momentum Investing with Mutual Funds
When it comes to momentum mutual funds, one of the factors considered by the fund manager is beta. Beta measures the stock’s volatility in relation to the overall market. You want a steep slope, essentially — the steeper, the better. This will indicate that if the market performs well, the momentum fund will perform even better.
However, one should understand that the risk associated with investing in momentum funds is high and the investor should consult their financial advisor before investing.
These funds use a variety of quantitative models and technical indicators to identify potential investments. They analyse price movements over periods ranging from six to twelve months to select those securities that are exhibiting strong relative performance. We suggest that investors should read the Scheme Information Document carefully and should only invest in these schemes on the basis of their risk appetite.
After all, the key is to identify the stock BEFORE the momentum fizzles out, not after.
“Currently, there are around 17 funds in this category. Of these, only two — managed by Samco and Quant AMC — are actively managed, while the remaining 15 are passive funds, including both index funds and ETFs.” — CNBC TV18 as of July 02, 2024
Passive momentum mutual funds track the performance of benchmark indices like the Nifty 200 Momentum 30 index or the Nifty Midcap 150 Momentum 50 index, or even the Nifty 500 index. Specific thematic funds may track other indices depending on the objectives of the scheme. As investors, you should read the Scheme Information Document carefully before deciding.
Like normal index funds, momentum-based passive mutual funds aim to track the performance of the index they track. They mirror the same portfolio with the objective of mirroring the returns as well.
However, please note that past performance may or may not be sustained in future.
Risks and Considerations
- Timing Risk
If there’s one thing anyone knows about the stock market, it is that nothing is permanent. Timing risk is when the future price predictions are erroneous and leads to losses. It explains the potential of missing out on beneficial price movements due to errors in timing. It could lead to purchasing too high or lessing too low.
Momentum strategies are particularly vulnerable during such periods, as they rely on the continuation of existing trends.
- Herd Mentality
Momentum investing can exacerbate herd behaviour. After all, investors are seeking to invest in high-performing stocks, and they can drive prices to unsustainable levels. This can increase the risk of sharp corrections, resulting in losses.
- Increased Volatility
Momentum investing involves high volatility. These stocks show a higher standard deviation than their conventional counterparts.
- Selection Risk
We cannot ignore the possibility of selection risk. It refers to the possibility that the stock or stocks selected will underperform for unexpected reasons.
Source: Extract from the news article https://www.moneycontrol.com/news/photos/business/personal-finance/does-momentum-investing-strategy-work-10990951-2.html dated June 23, 2023
Plus, frequent trading to capture short-term trends can lead to higher portfolio volatility and transaction costs.
Conclusion
Nothing in the world is ever purely black and white, and neither is momentum investing.
“One of the perils of a momentum-based strategy is that the momentum that is your friend for the moment can very quickly become your foe*.” — Ashwath Damodaran1
Investors need to temper their expectations, and exhibit reasonable caution when it comes to momentum investing.
Momentum investing with passive mutual funds may be considered a feasible option to take advantage of market trends as long as you’re comfortable with the risk exposure. Investing in these funds for the long term may potentially lead to potential returns, but as with all investments, returns are not guaranteed, and past performance does not indicate future results.
Use the Dezerv Wealth Monitor to check and review your portfolio and make sure your investments are working for you!
Frequently Asked Questions
- Is it good to invest in momentum mutual funds?
Momentum mutual funds can certainly help you generate potential returns for your portfolio by capturing market trends. It is based on the premise that stocks that are performing well will continue to perform well as more and more investors will join in. However, investors should understand that the risk associated with such theme-based schemes is high and they should consult their financial advisors before investing.
- Which is the best momentum mutual fund in India?
At present, there are about 17 momentum mutual funds in India, out of which 15 are passive in nature. Investors can choose any depending on their risk appetite and investment goals. Before taking any investment decision, we recommend that you should consult with your financial advisor.
- What are the disadvantages of momentum investing?
The main disadvantage of momentum investing is the higher exposure to volatility. You’re focussing more on price fluctuations instead of underlying fundamentals and this can be quite risky. If your timing is off, for instance, or if the momentum dies out soon after you invest, it can be quite a disaster.
Disclaimer:
Mutual Fund investments are subject to market risks, read all scheme related documents carefully. Mutual Fund distribution services are offered through Dezerv Distribution Services Private Limited, a wholly owned subsidiary of Dezerv Investments Private Limited (collectively referred to as “Dezerv”) with AMFI Registration No.: ARN- 248439.
The information contained in this article is for knowledge purposes only. This article should not be construed to be an offer to buy/sell any securities or provide any investment advice to any party. Please refer to the Scheme Information Document, Key Investment Memorandum, Statement of Additional Information, risk-o-meter, client agreement, and other related documents for mutual fund schemes including specific risk factors provided therein.
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