Momentum funds: Invest if you have long horizon and stomach for volatility

In a rising stock market, investors seek opportunities in upward-trending stocks. Momentum funds cater to this need by systematically identifying and capitalising on prevailing market trends. With growing interest, fund houses have begun to offer both active and passive momentum-focused schemes. A recent entrant is the new fund offer (NFO) of Motilal Oswal Active Momentum Fund.

 

“Momentum factor investing refers to the strategy of building a portfolio using stocks that have done well recently. It looks to benefit from the notion of winning stocks continuing to perform well in the near future,” says Sirshendu Basu, head-products, Bandhan Asset Management Company (AMC).

 

How momentum investing works

 

Momentum funds follow a thematic approach, buying stocks in an upward trend and selling when the trend reverses.

 

“One of the key strengths of this strategy is its ability to identify and latch on to emerging trends in the market. Although there may be a slight lag in detecting these trends, momentum investing in most cases gives itself enough time to benefit from ongoing trend changes,” says Karthik Kumar, fund manager, Axis Mutual Fund.

 

These funds rely on statistical tools to determine momentum and allocate capital accordingly.

 

“The momentum strategy is systematic and data-driven. The rules-based selection process minimises human biases. Also, the strategy dynamically allocates capital to sectors and stocks showing strength,” says Pratik Oswal, chief of business passive funds, Motilal Oswal AMC.

 

Volatility risk

 

While momentum funds are rewarding in a structural bull market, they can be highly volatile.

 

“Since momentum funds follow ongoing stock trends and use quantitative analysis, there is a probability of earning high returns. However, they can be highly volatile, especially in the short term. If the trend reverses, they could see sharp drawdowns,” says Parul Maheshwari, a certified financial planner.

 

They can also lag when trends within the markets shift. “If there is a radical shift in market conditions or the factors driving performance change abruptly, the momentum signal may not immediately reflect these new market realities. During these periods, the momentum strategy may struggle, posing a risk to short-term investors looking for quick gains,” says Kumar.

 

Active vs passive momentum funds

 

Active momentum funds use proprietary models, allowing fund managers to make investment decisions. Passive funds track momentum indices such as the Nifty200 Momentum 30 Index, aiming to replicate their performance.

 

“Active momentum funds offer the advantage of adaptability but can lead to frequent trading, impacting returns. However, they quickly adjust to evolving market trends. On the other hand, passive momentum funds are cost-effective and provide transparency, while lacking flexibility in unfavourable market conditions,” says Basu.

 

Oswal suggests that investors should look for fund houses with expertise and track record when choosing active momentum funds.

 

Who should invest?

 

Momentum funds suit aggressive investors with a long-term outlook.

 

“The momentum strategy, being inherently volatile, tends to be more unpredictable in the short to medium term and should be approached with a long-term perspective,” says Basu. He adds that momentum funds can be part of the satellite portfolio.

 

“Momentum funds are meant for aggressive equity investors only, who can take volatility and understand this style of fund management. Investors can allocate 10 to 25 per cent of their equity portfolio to such a strategy. They should hold them for a minimum of five years,” says Maheshwari.

 

Momentum funds can deliver strong returns in upwardly trending markets but require a high-risk appetite and long investment horizon.