Momentum factor funds: Invest only with 5-yr horizon, high risk tolerance

Use them as part of a portfolio containing multiple factor strategies

Motilal Oswal Asset Management Company (AMC) has launched the new fund offer (NFO) of the Motilal Oswal BSE Midcap 150 Momentum 30 Index Fund. Investors now have 27 single-factor momentum funds with combined assets under management (AUM) of ₹18,690 crore to choose from.

 

How momentum works

 

Momentum investing buys stocks that have outperformed their peers recently and avoids relatively weak performers. “The strategy assumes that stocks that have been doing well may continue to perform well for some time while weak stocks may continue to lag,” says Chetan Kukreja, chief of research – passive funds, Motilal Oswal Asset Management Company.

 

Momentum indices measure price movements over six and 12 months and adjust returns for volatility. “The strategy takes positions in rising stocks and exits them when their price trends show signs of reversal. The investor then moves to another set of firms whose prices display upward momentum,” says Chintan Haria, principal – investment strategy, ICICI Prudential AMC. 

 

Momentum runs counter to the instinct to buy low and sell high. “It assumes that stocks which have outperformed may continue to do so for some time because information gets reflected in prices gradually and investor behaviour often reinforces existing trends,” says Arihant Bardia, chief investment officer and founder, Valtrust.

 

The strategy favours companies where the market has begun to recognise improving fundamentals. “Improving earnings, stronger business performance or favourable industry dynamics often underpin sustained momentum. Purely speculative rallies rarely last for long periods,” says Bardia.

 

Differs from value and quality

 

The momentum strategy is very different from value or quality investing. Value investing seeks stocks trading below their estimated intrinsic value and waits for the market to recognise that value. “It uses measures such as the price-to-earnings ratio, price-to-book ratio, price-to-sales ratio and dividend yield,” says Ankit Singhania, head – passive business, Edelweiss Mutual Fund.

 

Quality investing uses parameters such as return on equity, the debt-equity ratio and variability in earnings-per-share growth. “It selects companies with strong fundamentals, healthy balance sheets, consistent earnings and sound management,” says Satish Dondapti, fund manager – exchange-traded fund (ETF), Kotak Mutual Fund.

 

Rules bring discipline

 

Momentum funds follow a transparent, predefined and rules-based process. “This approach removes dependence on an individual manager’s investment style or bias,” says Kukreja.

 

Singhania adds that smart beta funds are also generally more cost-efficient than actively managed funds.

 

A defined selection process has the potential to generate alpha over a broad index. “The strategy seeks to capture the maximum upside in stocks, while avoiding value traps,” says Haria. Bardia says that momentum has historically been one of the best-performing factors across global equity markets.

 

Momentum funds do well in bull markets and when trends and market leadership remain stable. “They typically benefit when recent winners continue to outperform,” says Kukreja.

 

Prepare for sharp swings

 

Momentum is among the more volatile investment styles, especially over the short to medium term. Midcap momentum funds, in particular, may fluctuate even more because midcap stocks have wider price swings and lower liquidity.

 

Historical declines show the potential severity. In 2008, the Nifty 200 Momentum 30, Nifty Midcap 150 Momentum 50 and Nifty 500 Momentum 50 indices fell 60 per cent, 65.1 per cent and 64.2 per cent, respectively.

 

Sharp reversals, directionless markets and frequent leadership changes can cause underperformance. “A sudden shift from a risk-on environment to a risk-off environment can also trigger sharp drawdowns,” says Bardia.

 

Investing on the basis of recent performance can be risky. “Investors who enter after a phase of strong recent performance may be disappointed when the cycle turns,” says Chirag Muni, executive director, Anand Rathi Wealth.

 

Concentration adds to the risk in these funds. “Factor indices select a limited number of stocks from their underlying benchmarks, which can increase stock and sector concentration,” says Muni. 

 

Rebalancing frequency also matters. “An index that rebalances only once every three or six months may continue to hold stocks that no longer meet its objective,” says Muni. Higher turnover can increase transaction costs.

 

Check suitability

 

Momentum funds may suit investors with an investment horizon of at least five years who can tolerate high volatility and withstand periods of underperformance. They may also appeal to investors who believe in the momentum style and prefer systematic rules to discretionary stock-picking. “They may also suit investors seeking diversification across investment styles instead of relying only on value or growth,” says Bardia.

 

Include in satellite portfolio

 

Investors should use momentum funds as a satellite allocation alongside a largecap or broad-market core holding. They should not form the foundation of the portfolio.

 

“Investors can take advantage of the volatility in these funds by investing via systematic investment plans (SIPs),” says Singhania. Finally, investors should not judge the strategy only by short-term performance because it may underperform periodically.

 

---

The writer is a Mumbai-based independent journalist