Momentum funds can see sharp reversals; limit satellite portfolio exposure

Check the underlying index and concentration, and invest for at least five years

Motilal Oswal Asset Management Company (AMC) has launched the new fund offer (NFO) for its Motilal Oswal Bombay Stock Exchange (BSE) Midcap 150 Momentum 30 Index Fund. The launch expands the range of smart beta momentum index funds and exchange-traded funds (ETFs) available to investors. 

These funds use a predefined, rules-based strategy to ride persistent price trends. They can outperform in a steadily rising market but may suffer sharp corrections when trends reverse. Investors must understand the underlying index, concentration risk, rebalancing frequency and the volatility they may face before they invest. 

How momentum works 

Momentum differs from value and quality strategies because it starts with price behaviour. 

“Momentum investing buys stocks with stronger recent price performance than their peers and avoids relatively weaker performers. It follows price trends using measures such as trailing 12-month returns adjusted for volatility,” says Chetan Kukreja, chief of research – passive funds, Motilal Oswal Asset Management Company. 

Value and quality strategies apply different filters. 

“Momentum investing is a price-based strategy that selects stocks with strong recent performance. Quality investing uses parameters such as return on equity, the debt-equity ratio and earnings-per-share growth variability, while value investing 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. 

Price is the primary screen, but this does not make the strategy purely speculative. 

“One common misconception is that momentum investing ignores fundamentals. While the screening process may begin with price strength, sustained momentum is often underpinned by improving earnings, better business performance or positive industry dynamics,” says Arihant Bardia, chief investment officer and founder, Valtrust. 

Narrower than broad indices 

Conventional midcap and momentum indices may start with the same universe but construct their portfolios differently.

“Conventional midcap index funds select stocks from the midcap universe and weight them mainly by free-float market capitalisation. Momentum funds select and weight stocks according to price momentum rather than only market capitalisation,” says Satish Dondapti, fund manager – ETF, Kotak Mutual Fund. 

A momentum score may use six-month and 12-month price returns adjusted for volatility. The BSE Midcap 150 Momentum 30 Index, for instance, selects the 30 strongest recent performers from the BSE Midcap 150. 

The underlying universe shapes the portfolio. The Nifty 200 Momentum 30 Index selects 30 companies from the Nifty 200, which comprises 100 largecap and 100 midcap companies. By contrast, a midcap momentum index remains confined to the more volatile midcap segment. 

“Momentum investing looks to benefit by taking positions in stocks going up and exiting them when there are signs of reversal. The strategy then moves to another set of companies whose prices show upward momentum,” says Chintan Haria, principal – investment strategy, ICICI Prudential AMC. 

Rules limit discretion 

The methodology specifies how the strategy selects and weights stocks. 

“A momentum fund follows a transparent, rules-based investment process rather than relying on a fund manager’s judgement. The predefined methodology removes emotional decision-making and ensures consistency and discipline in portfolio construction,” says Kukreja. 

Because these products follow a passive strategy, they can cost less than actively managed funds. Periodic rebalancing removes stocks that have lost momentum and adds those with stronger trends. 

Momentum can perform well when the market rises steadily and leadership remains stable. Stocks that already outperform may continue to lead, which allows the index to capture the trend. 

Trend reversals can hurt 

Momentum portfolios may trade more often than broad indices, which can raise transaction costs. 

“Momentum strategies are particularly effective in bull markets or periods of consistent upward momentum. They may, however, face sharper drawdowns when market trends reverse and tend to underperform broad market-cap indices in bear markets and flat markets,” says Singhania. 

The downside can be severe. 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. 

Midcap stocks can show larger price swings and have lower liquidity. A portfolio with only 30 stocks can also develop substantial stock and sector concentration. 

“Factor indices select a limited number of stocks from the underlying benchmark, creating greater concentration risk. Since these indices may rebalance only once every three or six months, they can continue holding a stock even after it has stopped meeting the strategy’s objective,” says Chirag Muni, executive director, Anand Rathi Wealth. 

This lag matters most when market leadership changes quickly. 

“Momentum funds generally underperform during highly volatile, range-bound or sharply reversing markets. In such phases, the index may continue holding recent winners until the next scheduled rebalancing even after market leadership changes,” says Dondapti. 

Momentum has also produced sharp year-to-year swings. The Nifty 200 Momentum 30 Index delivered about 52 per cent in 2021 but fell by about 6 per cent in 2022. It returned about 20 per cent in 2024 before falling by about 5.1 per cent in 2025.

“Momentum portfolios can witness sharp drawdowns when market leadership changes abruptly, particularly during heightened uncertainty or when the market transitions from a risk-on to a risk-off environment,” says Bardia. 

Check the underlying index 

Investors should first examine the index’s underlying universe. A strategy based on the Nifty 200 combines largecap and midcap exposure, while a midcap momentum index invests only in midcap companies. 

Investors should also check the number of constituents, stock and sector concentration, the period used to measure momentum, and how often the index rebalances. Long gaps between reviews can prevent the index from responding quickly when market conditions change. 

Investors should not equate a passive structure with low overall risk. These funds may cost less than actively managed funds, but concentration, turnover and sharp reversals can still hurt returns. 

Investors should not select a fund merely because its underlying index has recently delivered high returns. Strong recent performance may attract them just before the factor starts to underperform. 

Who should invest 

The strategy demands patience because returns can vary sharply across market cycles. 

“Momentum uses recent price trends to select stocks, but investors should have a long-term horizon because the strategy can face periods of underperformance. It is better suited as a satellite allocation complementing a diversified core portfolio,” says Haria. 

Investors who seek stable, index-like returns or cannot tolerate temporary losses and cyclical swings should avoid these funds. The strategy is also unsuitable for short investment horizons or for investors who chase recent returns. 

A systematic investment plan (SIP) can help investors average their purchase cost during volatile phases. It cannot eliminate risk, but it can reduce the danger of investing the entire amount after a strong run. 

“Momentum funds are suitable for investors with a medium- to long-term horizon who are comfortable with relatively higher volatility. They can be used as a satellite allocation alongside a core broad-market index fund,” says Dondapti. 

Investors should base the allocation on their ability to tolerate losses through a full market cycle. 

“Momentum works best as one style within a diversified equity allocation rather than as a standalone strategy. Combining it with value, quality or broad-market exposure can potentially improve risk-adjusted outcomes over a full market cycle,” says Bardia. 

Pros and cons of momentum strategy 

Pros 

•    Rules-based selection provides transparent momentum exposure without relying on a fund manager’s judgement’ 

•    The strategy can benefit when recent outperformers continue to lead over the next six to 12 months’ 

•    Volatility-adjusted scoring favours stocks with stronger risk-adjusted price momentum’ 

•    Stock-weight caps restrict the fund’s exposure to any single constituent’

  Cons

•    Momentum strategies can suffer sharp losses during rapid market rebounds after steep declines’ 

•    Factor cyclicality can cause momentum funds to underperform for prolonged periods’ 

•    Selection based on momentum can create sizeable stock and sector concentrations’

  The writer is a Mumbai-based independent journalist