Momentum funds: A friend that can quickly become your foe

Momentum mutual funds are a relatively new category. Like all novelty, it's exciting! But is it much ado about nothing? Let's see.

For the curious, momentum investing is a strategy that focuses on the premise of 'buy high and sell higher'. In this scenario, investors want to buy stocks that would continue to move up and sell them before they start performing poorly.

The surge in equity markets in 2021 and the initial first few months of 2022 led mutual fund houses to pursue momentum investing. As a result, fund houses have launched 11 momentum funds since 2022, and interestingly, all of them are passive funds. (Samco is launching the first active momentum mutual fund - the NFO is until June 29 - but that story is for another day).

Since all momentum funds, barring Samco's, track either the Nifty 200 Momentum 30 index or the Nifty Midcap 150 Momentum 50 index, we wanted to understand how these indices work and then gauge these funds' performance.

How momentum indices work
The Nifty 200 Momentum 30 index tracks the performance of the top 30 companies within the Nifty 200 that have the highest momentum score. This index is reviewed every six months (June and December).

The momentum score, which is a formula-driven calculation, is determined by taking an input from the 6-month and 12-month price returns of the stocks.

To qualify for the momentum index, stocks should be listed for more than one year and be available for trading in the derivatives segment.

The index is a mixture of 100 large-cap stocks and the top-100 mid-cap stocks.

What should investors keep in mind
While passive momentum funds have delivered 30-31 per cent returns compared to Sensex's 23 per cent , investors must remember that it is too soon to predict whether this fund category will continue to outperform the broader indices.

The strong performance is mainly due to the positive equity markets. It is not yet clear how these funds will do in different market cycles, especially in bearish and flattish markets.

In addition, the famous valuation guru, Ashwath Damodaran, wrote in his book 'Investment Fables: Exposing the Myths of "Can't Miss" Investment Strategies' that in momentum investing, holding a stock for too short or too long a period can both work against you.

Does this mean momentum funds are trying to time the market? Yes and no.

On the one hand, one might say that this is different from timing the market because stocks are chosen based on their previous performance. On the other hand, according to Damodaran, telling when momentum is shifting is one of the most difficult tasks in investing.

Like Damodaran says in his book, "One of the perils of a momentum-based strategy is that the momentum that is your friend for the moment can very quickly become your foe."

Also read: Complexity over simplicity