Momentum Fund - Meaning, How It Works and Benefits (2024)

A momentum fund is an investment vehicle that focuses on companies showing current trends in areas like earnings or price movements. Fund managers invest in companies exhibiting positive momentum while potentially shorting stocks of those showing negative momentum.

Many financial instruments use momentum factors in the investment world. However, the momentum fund is the only instrument that concentrates exclusively on harnessing a company’s stock's directional momentum.

What is a momentum fund?

A momentum fund is a specialised investment instrument that invests in companies according to ongoing trends. When we say trends, we essentially mean price dynamics and earnings. Fund managers invest in firms that exhibit positive momentum. However, if the momentum is negative, the fund manager of a momentum fund short-sells the stocks.

Momentum funds can provide you with significantly high returns. Despite this high return, you should be vigilant. This is because of the transient nature of momentum indicators, which causes fast directional shifts.

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Breaking down momentum funds

A wide range of factors contribute to momentum analysis. It can be movements in stock price, earnings, or revenue.

In the world of investments, various momentum indices have shot into prominence. Many ETFs (or exchange-traded funds) primarily focus on momentum. These ETFs track the performance of stocks (which are present in a certain momentum index) for the last year.

In addition, a momentum score is assigned by the momentum indices. This score includes multiple fundamental attributes, such as:

• Value
• Size
• Quality

This score is formulated by integrating two major aspects:

• Fundamental analysis
• Performance returns

When both these aspects are taken into consideration while creating the score, you get a comprehensive insight.

A technically oriented fund may invest according to indicators such as price breakouts from historical levels. When compared with funds based on technical analysis, momentum funds offer a more realistic outcome.

Historical market performance has always been given a significant weightage in momentum analysis. When including a stock, funds emphasise its past performance. This is because the fund managers believe that the past performance of a stock can help them get an idea about the stock’s future performance. This becomes more evident when the growth of revenue and earnings over time underpins positive performance.

Note of caution: You must be cautious while investing in such funds. This is because these funds exhibit a high correlation with systemic risks. In fact, they also tend to mirror the returns of the market closely.

Also read: What is a growth fund?

Momentum analysis

Momentum analysis has been a significant area of research, with studies indicating that momentum strategies can generate significant positive returns. The Efficient Market Hypothesis (EMH) has been tested in the Indian stock market, and the results suggest that momentum strategies can outperform the broader market.

For instance, a study found that momentum strategies can generate significant positive returns in the Indian stock market, with the weekly momentum strategy being particularly effective. This strategy involves buying stocks that have performed well in the past and selling those that have performed poorly, which can help investors generate significant profits. Behavioural factors may account for the momentum phenomenon, and introducing measures of "momentum quality" can help improve both return and downside performance.

Also read: What are Index Funds?

Investing in momentum funds

Investing in momentum funds can be a lucrative strategy for investors. Momentum funds track the performance of stocks that have shown strong growth in the past, and they typically use a combination of fundamental and technical analysis to identify these stocks. Momentum funds have been shown to outperform the broader market, with studies indicating that they can generate higher returns over the long term. Another study found that momentum exhibits a greater frequency of positive months than the index, with 63% compared to the index's 54%. However, momentum funds also come with higher volatility and drawdowns, which can be a challenge for investors. To mitigate these risks, investors can consider using a volatility-adjusted momentum strategy to help reduce the pain of drawdowns while retaining most of the upside.

Benefits of momentum funds

The top 4 momentum fund benefits are listed below:

1. Probability of high returns

Momentum funds follow the ongoing trends of stocks. You, as an investor, may earn high returns from your investment if you invest in stocks that have shown commendable strength and positive momentum recently. When a stock’s price appreciates further due to high momentum, you can make a significant amount of profit.

2. Quantifiable and objective approach

Quantitative analysis is one of the major pillars of momentum investing. It emphasises on two aspects:

• Observable price trends
• Performance metrics

This is a systematic and objective method of investment selection. It, therefore, helps in eliminating emotional biases from the process of decision-making.

3. Advantages of diversification

To identify stocks with uncorrelated price movements is a difficult task. However, you can solve this problem through momentum investing as it offers you the benefits of diversification. One thing you can do is invest in those multifarious sectoral stocks that demonstrate strong momentum. It will help you reduce the risk of your portfolio through diversification.

4. Active trading benefit

One of the highlights of all momentum strategies is the frequent buying/selling of stocks based on price trends, which are short-term in nature. As an active trader, you can exploit the inefficiencies of the market and create profit-making opportunities from short-term price movements.

Also read: What are equity funds?

Summary

Momentum trading helps you earn more profit by exploiting the momentum of stocks. In this process, two major strategies can be used by traders.

While one is relative momentum, the other is absolute momentum. In the case of relative momentum, you must compare the performance of different securities within a single class of asset. This strategy helps you invest only in well-performing assets and get rid of underperforming ones.

The other major momentum trading strategy is the absolute strategy. As per this strategy, a trader invests in stock only after comparing its price action with respect to its past performance over a specific time period.

As a trader, you should incorporate both of these strategies to make a profit based on the performance of stocks within and across asset classes.

Start investing in mutual funds as per your risk appetite. To assess your future investment, explore multiple mutual fund schemes at the Bajaj Finserv Mutual Fund Platform. Compare them by checking probable returns on the SIP calculator or the lumpsum calculator. What are you waiting for? Invest now.

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