Dwaipayan Bose explains what momentum investing is, how it works, why it generates higher returns and has higher wealth creation potential.
Factor based investing, which has been popular in developed markets, is becoming increasingly popular in India too.
Since January 1, 2024, 19 factor based index funds or smart beta funds were launched. Momentum is one of the most dominant factors in smart beta funds and has been in the news for the past six months.
In this article we will discuss why factor-based investing is gaining importance, with emphasis on momentum-based investing and funds.
What are smart beta funds?
Smart beta funds combine both passive and active methods of investing. These funds track factor indices, which are constructed on quantitative, rule-based investment strategies based on factors which historically drive portfolio returns and risk.
These factors can be momentum, low volatility, beta, alpha, value, quality, dividend yield, etc. Factor indices can be of two types:
- Single factor indices: Single factor indices select stocks from a certain investment universe (eg Nifty 50, Nifty 100, Nifty 500, etc) based on a single factor. For example, Nifty 500 Momentum 50 Index selects 50 companies with the highest momentum score based on six and 12-month price return adjusted for volatility from the Nifty 500 universe.
- Multi-factor indices: These indices select stocks from a certain investment universe (eg Nifty 50, Nifty 200, Nifty 500, etc) based on multiple factors. For example, the Nifty Alpha Low Volatility 30 index tracks the performance of 30 stocks which are selected based on the top combination of alpha and low volatility (both high alpha and low volatility) from the Nifty 100 and Nifty Midcap 50 indices.
Smart beta funds combine passive and active methods of investing; ie you can get alpha generation at much lower costs compared to actively managed funds.
Factor-based indices outperformed broad market indices
What is momentum?
Momentum refers to the tendency of stock price trends to persist.
It works on the premise that the stock market will continue to reward recent winners and they will continue to remain winners in the near term.
Similarly, losers will remain losers.
Momentum factor investing refers to taking advantage of this market behaviour to generate alphas by being overweight on winners.
Instead of the conventional 'buy low, sell high' approach, momentum strategy is essentially 'buying high and selling higher'.
How momentum investing works
- The momentum strategy is overweight on stocks that are outperforming and avoids/is underweight on stocks that are underperforming.
- The strategy picks a stock after it has moved upwards and proven its strength.
- It exits a stock that's not doing well once it identifies that the trend is continuing downward.
- Instead of predicting peaks or bottoms, the focus is on identifying and capitalising on the market’s trend.
- There is a perception that while momentum strategy is high risk, with increased downside risks during market corrections. But the trend following strategy can aid in lowering risks in down markets by dispassionately exiting past winners in down cycles.
- In essence, momentum aims to participate in winners and stick with them till they start declining.
Why momentum has the potential of creating alphas in your portfolio
The chart below shows the calendar year returns of momentum factor index versus the broad market index (Nifty 500).
While momentum underperformed in the years when the market was volatile, the margins of outperformance in the years when market was on an uptrend were significantly higher than the margin of underperformance versus the broad market index (see the chart below).
Over long investment tenures, momentum has the potential of creating alphas in your investment portfolio.
Higher wealth creation potential
The chart below shows the growth of Rs 10,000 in the momentum factor index (Nifty 500 Momentum 50 TRI) versus the broad market index, Nifty 500 TRI. TRI refers to Total Return Index, which takes into account all dividends/interest payments since the inception of the momentum factor index.
You can see the wealth created by momentum investing over long investment tenures.
Suitable for SIP
Since momentum stocks tend to be more volatile, you can take advantage of the volatility through rupee cost averaging by investing through a systematic investment plan.
The chart below shows the growth of a Rs 10,000 monthly SIP in a momentum factor index (Nifty 500 Momentum 50 TRI) since the inception of the factor index (nearly 20 years back).
With a cumulative investment of around Rs 24 lakhs, you could have accumulated a corpus of Rs 2.6 crore.
Who should invest in momentum funds?
- Investors seeking capital appreciation over long investment tenures.
- Investors seeking to add aggressive strategy to their portfolio.
- Investors with a high-risk appetite.
- Investors having a long-term investment horizon (minimum five years).
Investors should consult their financial advisors or mutual fund distributors about which momentum fund is suitable for their investment needs.
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Disclaimer: This advisory is meant for information purposes only. This advisory and the information in it does not constitute distribution, an endorsement, an investment advice, an offer to buy or sell or the solicitation of an offer to buy or sell any securities/schemes or any other financial products/investment products mentioned in this article or an attempt to influence the opinion or behaviour of the investors/recipients.
Any use of the information/any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.
Dwaipayan Bose leads content production and mutual fund research at 
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