Momentum Investing: What is it, its Strategies & How it Works (2024)

In this blog, we will explain what momentum investing is, how to build a strategy for it, and also look at how it has performed in India over the years.

What is Momentum Investing?

For decades, the core to investing has been to buy low and sell high. And this is where momentum investing is different.

Investors who practice momentum investing are not discouraged by a high price or by the fact that the price of a stock is rising. On the contrary, these investors are actually attracted to a company whose price is on an upward trajectory. Momentum investors pin their hopes that this upward price momentum will continue for some more time and they will be able to sell at a higher price.

Nevertheless, momentum need not always be positive and upwards. There is also the downward momentum whose premise is that the stocks that have underperformed recently have a tendency to go down even further in the short term. It’s this high-higher and low-lower effect that the entire momentum strategy hinges on.

Cause of Momentum Effect

There are two plausible explanations that explain the momentum effect.

The first explanation comes from behavioral finance which links it to investor bias. Investors often overreact or under-react to information which leads to pricing inefficiencies.

A second explanation is offered in terms of timing. Investors initially react slowly to new information and then do a hurried follow-up on it which drives momentum. And this catchup nature is probably why momentum investing has always been a short-term strategy. It often plays its part over 6 to 12 months.

Building A Momentum Strategy

There are many ways of implementing a momentum investing strategy. One of the strategies involves a set of rules aimed at investing in the best-performing stocks over the past 6 months for the subsequent 6 months. In the same context, one can also short (or in other words sell) the worst performers from the past 6 months for the next 6 months.

“Shorting stocks” is a technique where you first sell a stock and then after some time buy back the stock thereby netting off your position. In other words, the short seller is betting that the price of the stock will fall and he can buy the stock at a lower price and make a profit in the process.

Momentum Investing: Does it Work?

To examine the effectiveness of momentum investing, we created our own momentum investing model. A defined universe of stocks such as NIFTY 50 was taken and the historical stock prices at a 6-month interval were mapped.

The periods that were taken with a 6-month window for this calculation included Sep 2018, Mar 2019, Sep 2019, Mar 2020, and then Sep 2020. We identified the best performing 10 stocks and worst-performing 10 stocks for these 6-month intervals of Sep 2018 – Mar 2019, Mar 2019 – Sep 2019, and so on.

Then two scenarios were applied. Scenario 1 is where we follow the upward momentum strategy and buy the top-performing stocks for a period of 6 months and ignore the worst-performing stocks. In this scenario, momentum strategy would have given absolute returns of 1%, 6%, 16%, and 36% in those 6-month periods.

In scenario 2, instead of buying the stocks as we did in Scenario 1, we started to short the stocks using a downward momentum strategy.

When the 10 worst-performing stocks in our model were short, the period of March-September 2019 and then September 2019 to March 2020 were extremely profitable with gains of 16% and 28%.

However, this downward momentum strategy went dramatically wrong from March 2020 to March 2021 with an 18% and 52% loss in these two 6-month periods, respectively.

Another scenario is the combination of scenario 1 and scenario 2. In the real world, all hedge funds follow a long-short scenario which is a combination of scenario 1 and scenario 2. They believe that there is money to be made when there is positive momentum and there is money to be made when there is negative momentum.

So, if the top 10 performing stocks were bought and the 10 worst performers were short, then here is how the results would have stacked up.

In the first two intervals, the long-short strategy would have really been profitable and the absolute returns would have been 20% and 40% over the NIFTY 50. However, in the next two intervals, the long-short strategy would have underperformed the NIFTY 50 especially on account of downward momentum being non-existent.

Of course, a smart hedge fund manager would have figured out that one has to approach market shocks differently from a steadily rising market. This is because, in situations where the markets have fallen dramatically, it’s probable that the past worst performers recover faster than the past best performers.

The NIFTY 200 Momentum 30 Index

Momentum investing has been in use for over 200 years but was generally ignored as a branch of study until the 1990s. It’s in the last 10 years or so that passive investing based on momentum strategies has come up and is seeing a lot of traction.

In India, there are two momentum-based benchmarks –

• The S&P BSE Momentum Index which was launched in December 2015
• And NIFTY 200 Momentum 30 Index, which was launched by NSE Indices in August 2020

Let us understand the details of the NIFTY 200 Momentum 30 Index, as it is available in an index fund byUTI Mutual Fund.

The construct of a momentum index is based on a set of rules and criteria which can be divided into 5 separate buckets.

1. The universe of stocks
2. The basic construct
3. The weighting criteria
4. The constraints
5. And finally the periodic maintenance

• Universe

The NIFTY 200 Momentum 30 Index, as the name suggests, works around the top 200 companies listed on NSE. The NIFTY 200 is a pretty formidable index that represents about 87% of the free-float market capitalization of the stocks listed on the NSE. Out of these 200 stocks, the momentum 30 index is only looking for companies that have a listing history of at least 1 year and are available for trading in the derivatives or the F&O segment. These filters shrink the available universe from 200 stocks to around 130 companies.

• Basic Construct

The NIFTY 200 Momentum 30 index selects 30 stocks from its universe in an unbiased rule-based methodology. The stocks selected are based on their normalized momentum score. This score is determined on the basis of any stock’s 6 months and 12-month price return after adjusting for their daily price volatility.

The reason why the construct gives consideration to normalization and volatility is that it aims to eliminate the impact of immediate spikes in the momentum score. For instance, assume a biotech company’s stock price suddenly spikes up after the release of favorable clinical trial results. So while there is short-term positive momentum, it is also very common to see that these gains may not persist for long. And for this reason, normalizing and adjusting the selection criteria based on volatility gives the momentum strategy a higher chance to yield better results

• Weighting Criteria

The NIFTY 200 Momentum 30 Index uses stock weights as a combination of the stock’s normalized momentum score and its free-float market capitalization. The normalized momentum score has been explained above.

In free-float methodology, the market capitalization of a stock is calculated by multiplying its price by the number of shares readily available in the market. So this method excludes locked-in shares such as those held by insiders, promoters, and governments.

• Constraints

With regards to constraints, the weights of any stock in this index are capped at the lower of 5% or 5 times the weight of that stock in the NIFTY 200 index. This 5% capping is generally done to avoid portfolio skewness towards a particular stock and to ensure there is adequate diversification.

• Rebalancing

And finally, the index does a rebalancing on a semi-annual basis in June and December every year.

Performance of Momentum Investing Strategy

Globally, momentum investing has enjoyed a strong run for many years with cracks only showing when the stock markets went into a tailspin as experienced in the years 2000, 2008, and 2020. From an Indian context, a good way to judge performance is by drawing comparisons between the NIFTY 200 Momentum 30 index and other available indices. For this purpose, we chose 4 popular indices: the NIFTY 50, the NIFTY Next 50, the NIFTY Midcap 150, and the NIFTY 200.

The NIFTY 200 was a mandatory benchmark comparison point as it uses the same universe of stocks as the Momentum index. Comparing the NIFTY 50 with the NIFTY 200 Momentum 30 index is not an apple to apple comparison, but the idea is to form some sort of a basis or understanding.

Here is what 15 years of data shows.

Notice that 2008 and 2009 were the periods when the Momentum 30 strategy couldn’t match most of the other indices. This was also the time when the stock markets were dented by the financial crisis. But that doesn’t seem to be anything more than an aberration. In 7 out of the 15 years under consideration, the NIFTY 200 Momentum 30 Index was the highest performing index across all five indices.

In fact, the NIFTY 200 Momentum 30 Index has returned more than the NIFTY 50 in 10 years and has overpowered the NIFTY 200 in 12 years.

Now let’s look at the data from the basis of a rolling return. Five-year rolling period data was taken for evaluation and the data were evaluated on a monthly basis. The analysis starts from January 2011, which measures the annualized returns from January 2006 to January 2011.

The data shows that in the next 10 years (120 months) from Jan 2011, the momentum 30 strategy has delivered the highest returns amongst all five strategies in 76% of these 120 months

In fact, since August 2014, in 100% of the 77 months under consideration, the momentum 30 index has delivered the highest 5-year rolling returns.

ETMONEY Opinion

Should you invest in a momentum index fund?

Perhaps the best way to examine this is by looking at the benefits and concerns posed by this strategy. Let’s look at it from the point of view of the NIFTY 200 Momentum 30 Index fund.

Firstly, UTI Nifty 200 Momentum 30 Index Fund is a passive index fund which means all systems on selection, ranking, weights, inclusions, exclusions, cappings, etc. are all automated. And there are no biases like what we see in an actively managed fund.

Additionally, the methodology used in calculating the index values is available in the public domain so if anyone uses that and does the same analysis, then one will get the same results. So there is a lot of transparency here.

The second point of note is that the Momentum 30 index can often give a starkly different portfolio mix as compared to the benchmark. A case in point is the latest portfolio mix of the NIFTY 200 and the Momentum 30 Index. So while financial services are over 35% in the NIFTY 200 index, it is less than 10% in the Momentum 30 index. There is a higher allocation to pharma, IT, and metals in the Momentum 30 index currently due to the great run-up these sectors have had in the last 12 months.

This again can be beneficial as it allows for some tactical diversification from the rest of your mutual fund portfolio.

In terms of the gaps or concerns, there are some studies that say that a 6-month rebalancing might be a bit too long and that rebalancing should be done every 2 or 3 months. Additionally, some global momentum-based funds also have in-built alerts that allow the system to automatically rebalance at times of big spikes and big shocks. The builders of the NIFTY 200 Momentum 30 Index have not opted for these practices.

Another concern is that momentum funds can be more volatile than other funds in spite of the automated rules which are in place.

And the final observation was with regards to the impact of this regular churning of portfolio .. which is likely to lead to a relatively higher expense ratio. The word relatively holds the key here as we are used to the expense ratios of 0.1 to 0.2% when it comes to index funds. But in the case of UTI’s NIFTY 200 Momentum 30 Index Fund offering, the expense ratio may be anywhere from 0.4% to 0.5%. This is something to note, but not something that should worry you too much if the performance delta is on the higher side.

Overall, the UTI Nifty 200 Momentum 30 Index Fund can be a good addition to a long-term and disciplined investing portfolio. In fact, a monthly SIP started from January 2006 would have yielded a delicious 16.9% annualized returns based on the momentum strategy, as compared to 11.3% returns from the NIFTY 50.

So, have a think about it and let us know in the comments box what you think about this strategy.