Momentum & alpha funds: Better than even small-cap funds?

If you thought small-cap funds have been rocking it, let us introduce you to momentum and alpha funds. Over the last 12 months, six momentum and alpha funds - i) Nifty 200 Alpha 30 ii) Nifty Alpha 50 iii) Nifty Alpha Low Volatility 30 iv) Nifty 200 Momentum 30 v) Nifty Mid-Small Cap 400 Momentum Quality 100 vi) Nifty Small-cap 250 Momentum Quality 100) - have gunned out 59 per cent growth on average, much higher than even the impressive small-cap index's 53 per cent returns.

Sitting on the high table with small caps (and even mid-caps) is no small feat. Beating them in a bull run is even more impressive. No wonder the smart money is looking at momentum and alpha strategies with keen interest.

But before you accuse us of short-termism, let's look at their simulated long-term performance. Simulated because we had to back-test the data as the funds tracking these strategies are fairly young.

Even on that front, they seem pretty solid. Here's what we found when we looked at their five-year rolling daily return from April 1, 2010, to September 13, 2024, and compared them with their parent indices.

• Alpha funds delivered the highest five-year rolling returns but also exhibited sharper drawdowns, indicating high volatility (standard deviation).
  
• Momentum funds maintained strong median performance and had comparatively limited negative returns. However, their volatility is concerning.
  
• Overall, momentum and alpha indices outperform their parent indices (Nifty 200, Nifty 100, and Nifty Smallcap 250) but suffer deeper cuts in bearish markets.
  
• Low volatility and quality-focused versions of these indices outperformed small- and mid-cap indices with relatively lower volatility. However, other momentum and alpha funds underwent higher fluctuations, suffering more days of negative five-year rolling returns than their parent indices.

In short, momentum and alpha indices have performed well in the long term but can be volatile, especially during market downturns.

Other points to consider

Danger of duplication
Given the stellar returns, getting a larger pie of momentum and alpha funds is tempting. But beware: momentum and alpha funds can have significant portfolio overlaps, investing in many of the same stocks.

For instance, 22 of the 30 stocks bought by the Nifty 200 Alpha 30 and Nifty 200 Momentum 30 indices are the same, as of September 2024. As such, 62 per cent of their money is invested in the same stocks.

Hence, investing in both strategies will only increase duplication and minimise the benefits of diversification.

High churn rate of stocks
Momentum and alpha indices frequently churn their portfolios. Momentum indices select stocks with the strongest price movement over the last 6 to 12 months, while alpha indices focus on stocks that consistently generate excess returns compared to the market benchmark.

This constant search for winners results in a high churn rate, which can become problematic if the fund grows too large to buy and sell stocks at a higher frequency.

Slightly more concentrated
The top three sectors in the momentum and alpha indices have 50-53 per cent weightage, against the Nifty Smallcap 250's 40.9 per cent and the Nifty Midcap 150's 38.68 per cent, suggesting the strategy indices can be more prone to volatility, especially during sectoral rotations.

Inclusion of low-quality stocks
At the fag-end of a bubble, low-quality stocks with weak fundamentals tend to rally and thus get included in momentum and alpha-based indices. But when the bubble bursts, they eventually crash. This is perhaps one of the reasons why momentum and alpha indices see deeper corrections during market slowdowns.

Our take

Alpha and momentum indices have delivered impressive returns recently, but they do have inherent risks.

Additionally, the above long-term analysis is largely based on back-tested data, which might differ from their real-world performance, particularly during bearish markets.

Thus, style-based investing in momentum and alpha funds should only comprise a small portion of your portfolio.

Also read: Is micro-cap index better than small caps?