Pratik Oswal, Head - Passive Funds, Motilal Oswal AMC.
Credit: Special Arrangement.
Momentum investing is an investment strategy that may sound complex, but it’s grounded in a straightforward idea: assets that have performed well recently are likely to continue performing well in the near future. Investors using this strategy aim to “ride the wave” of rising trends and potentially earn higher returns. Research shows that over time, momentum investing can often outperform traditional strategies, offering an appealing option for both novice and seasoned investors.
How it works
Momentum investing is based on following trends rather than picking undervalued stocks, as value investors do. Instead of searching for “hidden gems,” momentum investors focus on assets that are already on an upward trajectory. However, this doesn’t mean investors need to actively manage individual stocks. They can easily take advantage of this strategy through momentum-based exchange-traded funds (ETFs) or index funds.
These funds track stocks that have demonstrated strong price performance over the last 6 to 12 months, with adjustments for volatility. Regular rebalancing ensures the portfolio stays up-to-date with the best-performing stocks. This allows investors to benefit from momentum without needing to constantly monitor the market. Essentially, it offers the opportunity for higher returns without the complexity of active stock-picking.
Capturing sector and market cap trends
One of the key benefits of momentum investing is its ability to track the best-performing sectors. For example, if the technology sector is experiencing rapid growth, momentum funds will allocate more weight to stocks within that sector. This gives investors exposure to booming industries at the right time, helping them capitalise on growth trends.
Similarly, momentum strategies are adaptive when it comes to market capitalisation. During periods of economic growth, small-cap stocks often show higher returns, and momentum funds shift towards them. Conversely, during times of uncertainty or economic slowdown, these funds may increase their allocation to large-cap stocks, which tend to offer more stability. This dynamic approach enables momentum investors to align with the prevailing market conditions, maximising their chances of success.
Why it works
Momentum investing is driven by a few key market patterns that explain why this strategy has historically delivered strong returns:
1. Slow reactions from traditional investors: Many traditional investors underreact to short-term market movements while overreacting to long-term trends. This creates an opportunity for momentum investors, who can identify and capitalise on trends early. For instance, a sector like public utilities may rally for several years, but it’s often only after this trend is well-established that many investors take notice. Momentum strategies allow investors to enter positions earlier and benefit from sustained growth.
2. Market inertia: Large institutional investors, such as pension funds and mutual funds, tend to move slowly when adjusting their portfolios. This gradual shift creates trends that can persist for months or even years, providing momentum investors with a window of opportunity to profit from these long-term trends. By investing in a diversified portfolio, typically containing 30-50 stocks, momentum investors reduce the risk of underperformance from a few individual stocks, while still riding broader market trends.
Benefits
Momentum investing offers several advantages, particularly the potential for higher returns compared to traditional index funds. By investing in momentum-based funds, investors gain exposure to market trends without needing to actively manage their portfolios. These funds provide a simple, low-maintenance way to harness the power of momentum, offering higher returns while maintaining the simplicity and cost-effectiveness of passive investing.
For those seeking to add a dynamic element to their portfolio, momentum-based strategies offer an efficient way to capture sector and market trends, delivering growth without the complexities of daily trading.