Why Momentum Investing Matters

In a world where the only constant is change, momentum investing stands as a strategy that aligns with the winds of transformation, helping investors to earn better returns. The article highlights how it works in favour of investors 

In the fast-paced world of investing, staying ahead of the curve is often the key to success. Financial markets are dynamic, reflecting the constant evolution of industries and technologies. Consider this: Today’s largest companies worldwide were once fledgling start-ups a few decades ago and the rapid disruptions that shape our corporate landscape have a profound impact on their share prices. From Silicon Valley to the heart of India’s bustling technology scene, the world is witnessing a transformation where even giants can become dwarfs overnight. 

Take, for instance, the United States. Technology giants like Apple and Amazon, now among the world’s largest companies, are very young and were once disruptors themselves, reshaping entire industries in the process. The rise of smart phones revolutionised communication, while e-commerce changed the way we shop. Investors who recognised these transformative shifts early reaped the rewards as the stock prices of these companies surged. This phenomenon is not unique to the US. [EasyDNNnews:PaidContentStart]

Similar stories have unfolded in India’s burgeoning start-up ecosystem, where companies like Zomato and Paytm have disrupted traditional business models. In the world of finance, tracking sectoral performance can be a challenging endeavour. Entire industries can go through cycles of growth, stagnation or decline that span years or even decades. Recognising these shifts and making timely investment decisions is often easier said than done. This is where momentum investing comes into play. Such an approach carries a generic belief that price is the king and a true reflection of the investors’ sentiments towards the stocks. 

Momentum Investing

Momentum investing is a strategy that aims to capitalise on the recent performance of stocks or assets. To effectively implement this strategy, it addresses several core questions:

1. What to Buy - Momentum investing seeks to identify which stocks or assets to include in the investment portfolio. It focuses on selecting those securities that have exhibited strong recent performance, such as stocks with rising prices over a specific look-back period, often the past 6-12 months.
2. When to Buy - Timing is critical in momentum investing. It aims to buy securities at the right moment when their recent performance suggests a potential uptrend will continue. Investors look for signs of sustained positive momentum before making an entry into the market.
3. How Much to Buy - Determining the appropriate allocation of capital to each selected security is a crucial aspect of momentum investing. The strategy typically involves equal-weighting or allocating more capital to the best-performing securities within the portfolio. The idea is to maximise exposure to the strongest momentum factors. 
4. When to Sell - Just as important as knowing when to buy is the understanding of when to sell. Momentum investors need predefined exit strategies. They may choose to sell a security if its momentum weakens or if some specific criteria for exiting the position are met. Some investors use trailing stop-loss orders or technical indicators to guide their sell decisions. 

Momentum investing, a strategy that prioritises stocks that have demonstrated price increases over a specific period, offers a practical approach to navigate these market dynamics. This approach is grounded in the belief that stocks that have been on the rise are likely to continue their upward trajectory. By identifying these stocks and capitalising on their momentum and without paying much attention towards other aspects of the companies, investors aim to ride the wave of market optimism and make good on the opportunities presented by the changing economic landscapes. 

Momentum in India

There has been more than 200 years of evidence that momentum works. Even in India it seems to work. To understand if momentum works, we analysed the performance of Nifty 200 Momentum 30 index and compared this with Nifty 50. The Nifty 200 Momentum 30 index aims to track the performance of 30 high momentum stocks which are part of the Nifty 200 index. The stocks forming part of the Nifty 200 index and also part of the derivative segment are eligible for inclusion in Nifty 200 Momentum 30 index. Further, stocks based on their six months’ and 12 months’ volatility adjusted returns – known as normalised momentum score – are considered to be part of the overall portfolio. 

The top 30 stocks having the highest normalised momentum score make the Nifty 200 Momentum 30 index. The weight of each stock is decided based on a factor tilt method i.e. at the time of re-balance the weight is decided based on its momentum score and free float market capitalisation. The weights are capped at an upper limit of 5 per cent at the time of rebalancing. Every ₹ 1 lakh invested in Nifty Momentum index at the start of April 2005 would have become ₹ 22.91 lakhs. Compare this with Nifty 50 where you would have earned only ₹ 9.46 lakhs. These indices have generated annualised return of 18.5 per cent and 12.9 per cent, respectively. Even year-till-date, the Nifty Momentum index has given return of 17.85 per cent compared to 7.84 per cent by Nifty 50.

Going one step ahead, we calculated the yearly return of these two indices to understand the consistency in outperformance. The table presents a compelling picture of the outperformance of the Nifty Momentum index compared to the broader Nifty index over the years. In nearly every year, Nifty Momentum has exhibited stronger returns than Nifty. Notably, in the turbulent year of 2008, when the global financial crisis wreaked havoc on the markets, both indices posted negative returns, but Nifty Momentum demonstrated inferior performance compare to Nifty. 

This trend continued through the following years with Nifty consistently surpassing Nifty Momentum’s performance. Nonetheless, in particular, 2007 and 2017 stand out as exceptional years for Nifty Momentum with substantial gains dwarfing those of Nifty. Even in more recent years, such as 2021, Nifty Momentum maintained its remarkable outperformance, underscoring the potential benefits of a momentum-based investment strategy in navigating the complexities of the financial markets. There were five instances in the last 18 years when Nifty Momentum underperformed Nifty.

While the Nifty Momentum index has consistently outperformed the broader Nifty index over the years, it’s important to note that this outperformance can come with increased vulnerability to larger drawdown when the overall market sentiment is unfavourable. This vulnerability was evident during the challenging year of 2008 and more recently in 2022 when the broader market faced difficulties. In both instances, Nifty Momentum experienced more significant drawdown compared to the Nifty index. The following chart provides a visual representation of the drawdown experienced by both indices, highlighting the potential trade-off between superior performance during bullish periods and heightened sensitivity to market downturns.

Performance at Glance

The significance of the Nifty Momentum index becomes abundantly clear when we examine its performance metrics in comparison to the broader Nifty index over an extended period. From its inception on April 4, 2005 to September 28, 2023, the Nifty Momentum index delivered an astounding total return of 2,191.57 per cent, far surpassing Nifty’s 846.21 per cent. This remarkable outperformance is underscored by metrics such as the daily Sharpe ratio (0.87 for Nifty Momentum versus 0.68 for Nifty) and the daily Sortino ratio (1.36 for Nifty Momentum versus 1.08 for Nifty). 

They reflect not only higher returns but also superior riskadjusted performance. Furthermore, the compound annual growth rate (CAGR) for Nifty Momentum stands at an impressive 18.46 per cent compared to Nifty’s 12.93 per cent. Nonetheless, when considering downside risk, as indicated by the maximum drawdown, Nifty Momentum exhibits larger drawdown of 67.89 per cent compared to Nifty’s 59.86 per cent.

Types of Momentum

Momentum investing relies on the principle that securities that have performed well in the past will continue to do so in the future. There are several ways to calculate and implement momentum strategies, each with their own nuances. Here are some different types of momentum investing calculations:

1. Price Momentum - Price momentum is the most straightforward form of momentum investing. It involves ranking securities based on their recent price performance, typically over a specified look-back period, such as the past 6-12 months. Stocks that have shown the highest price appreciation are considered strong momentum candidates.
2. Relative Strength Momentum - Relative strength momentum compares the performance of a security to that of a benchmark index or another asset class. It measures the relative performance of a security, indicating whether it has been outperforming or underperforming its peers or the market as a whole.
3. Risk-Adjusted Momentum - This approach incorporates risk into the momentum calculation. One common measure used is the Sharpe ratio, which accounts for the return of an asset relative to its risk (volatility). Securities with high risk-adjusted returns are favoured in this strategy.
4. Fundamental Momentum - In addition to price-based metrics, fundamental momentum considers factors like earnings, revenue growth or other fundamental indicators. Stocks with strong recent fundamental performance are considered for inclusion in the portfolio.
5. Moving Average Momentum - Moving averages, such as the 50-day or 200-day moving average, are used to identify trends in stock prices. A security trading above its moving average may be considered for inclusion in the portfolio.
6. Cross-Asset Momentum - This strategy extends beyond individual stocks and can involve momentum investing across various asset classes, including stocks, bonds, commodities and currencies. It aims to select the strongestperforming asset class for investment.
7. Volatility-Based Momentum - Some strategies incorporate volatility as a factor in momentum calculations. High volatility may indicate increased investor interest and potential for strong price movements.
8. Sector Rotation Momentum - This strategy involves rotating investments among different sectors of the market based on their relative strength or performance. It aims to capitalise on sector-specific trends. 

Our Momentum Portfolio

To understand if momentum performs beyond the top 200 companies, we computed and analysed momentum stocks from the BSE 500 universe. For this on the first trading day of the month, we ranked all the stocks based on their absolute return over the last 52 weeks or one year. We bought the top 10 stocks in equal weight from this list. This is a long-only strategy and the portfolio was rebalanced every month. We started our portfolio from October 2022, which means we took data from October 2021 to September 2022 to calculate the momentum rank and construct the portfolio. 

This was rebalanced every month by calculating momentum score of the last one year’s returns. The momentum portfolio generated extraordinary returns and more than doubled the money in the last one year compared to a modest return of 9 per cent by Nifty 50 in the same period. Momentum investing is a popular strategy that has garnered attention for its potential to outperform the market over the years.

When Momentum Can Lose Momentum

One of the primary drawbacks of momentum investing is the risk of price reversals. Stocks that have experienced strong momentum can quickly reverse course, leading to substantial losses for investors who fail to exit in time. We saw this in the year 2008. Besides, momentum investing requires discipline and a contrarian mindset. Investors must be willing to buy stocks with strong recent performance, even if they seem overvalued, and sell stocks with poor recent performance, even if they appear undervalued. 

This can be psychologically challenging. Also, momentum strategies often disregard fundamental analysis, such as a company’s financial health, earnings and valuation metrics. This can lead to investments in stocks that may be fundamentally weak but are riding a short-term price wave. Momentum investing may falter in bear markets or during periods of market turmoil such momentum strategies can result in significant losses as price trends become less predictable. 

Conclusion

Momentum investing offers both potential rewards and risks. While it has historically outperformed in certain conditions, investors should be aware of its limitations and the need for disciplined execution. This strategy is not a one-size-fits-all solution and should be considered within the broader context of an investor’s goals and risk tolerance. Understanding when and where momentum works can help investors harness its benefits while minimising its drawbacks. 

In conclusion, the world of finance is in a constant state of flux. To thrive in this ever-changing environment, investors need strategies that allow them to keep pace with shifting market dynamics. Momentum investing, with its focus on stocks that have demonstrated price increases, offers a prudent way to harness the power of change and make the most of evolving opportunities. 

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