What Are Momentum Funds? A Simple Guide

Think of the stock market like a cricket match where certain players are on a hot streak. Momentum funds work on a similar principle they back companies whose share prices are already moving upward, betting that the winning streak will continue.

Most investors know about value investing, where you hunt for undervalued stocks trading below their worth. Momentum investing takes the opposite approach. Instead of buying cheap stocks hoping they’ll rise, momentum funds buy stocks that are already rising, expecting the upward trend to persist.

How Momentum Funds Actually Work

Momentum funds use a straightforward strategy. Fund managers identify stocks that have shown strong price performance over recent months  typically 3 to 12 months. They then invest in these winners, believing that stocks which have performed well recently will continue to outperform in the near term.

This approach stems from a behavioural finance concept: trends tend to continue before they reverse. Just like how a batsman in form often continues scoring runs across several matches, stocks that are performing well often keep rising for extended periods.

The fund managers regularly review their portfolios, usually monthly or quarterly. Stocks that lose momentum get sold, while new high performers get added. This creates a dynamic portfolio that constantly adapts to market trends.

1. The Science Behind Momentum

Research shows that momentum works because of human psychology. When a company reports good results or positive news, investors initially under-react. But as more investors notice the trend, they jump in, pushing prices higher. This creates a self-reinforcing cycle.

In Indian markets, we’ve seen this play out repeatedly. Consider the IT sector’s rally during the pandemic or the recent surge in renewable energy stocks. Early momentum often builds as institutional investors and then retail investors gradually recognise the trend.

The strategy works particularly well in trending markets. When sectors like pharmaceuticals or metals are in favour, momentum funds can capture significant gains by riding these waves rather than fighting them.

2. Types of Momentum Strategies

Pure momentum funds focus solely on price trends. They buy stocks showing the strongest price appreciation regardless of the sector or company fundamentals. These funds are completely trend driven.

Factor based momentum funds combine price momentum with other factors like earnings growth or improving financial metrics. They look for companies where both stock prices and business fundamentals are moving in the same positive direction.

Sector momentum funds identify sectors showing strong performance and invest across companies within those sectors. For instance, if banking stocks are outperforming, the fund might allocate heavily to various banks and financial services companies.

3. Benefits of Momentum Investing

Momentum funds can deliver impressive returns during trending markets. When markets are moving strongly in one direction, these funds often outperform traditional diversified equity funds because they concentrate on winning stocks and sectors.

The strategy helps investors avoid value traps  stocks that appear cheap but continue falling. Instead of catching a falling knife, momentum investors wait for confirmation that a trend is established before investing.

These funds also benefit from reduced emotional decision making. The systematic approach of buying high performing stocks removes the guesswork and emotional biases that often hurt individual investors.

4. Risks You Should Know

Momentum investing comes with higher volatility. When trends reverse, momentum funds can experience sharp declines because they’re concentrated in stocks that may all fall together.

The strategy typically involves higher portfolio turnover as managers frequently buy and sell stocks based on changing trends. This can lead to higher transaction costs, which may impact returns.

Momentum funds often perform poorly during market transitions or sideways markets where clear trends don’t emerge. They need strong directional moves to generate alpha.

There’s also the risk of buying at peaks. By definition, momentum funds buy stocks that have already risen significantly, which means they might enter positions near temporary tops.

5. Who Should Consider Momentum Funds

Momentum funds suit investors with higher risk tolerance who want to participate in trending markets. They work well for investors who understand that returns will be lumpy. Some periods will show excellent performance while others might disappoint.

These funds can complement a diversified portfolio rather than forming its core. Adding 10-20% allocation to momentum funds while maintaining exposure to value and growth strategies can help capture different market cycles.

Investors with investment horizons of 3-5 years who can handle short-term volatility might find momentum funds attractive. The strategy needs time to work through different market cycles.

6. How to Evaluate Momentum Funds

Look at the fund’s methodology for selecting stocks. Some funds use simple price based screens while others incorporate multiple factors. Understanding the approach helps set proper expectations.

Check the fund’s performance during different market conditions. Good momentum funds should significantly outperform during trending markets while limiting downside during reversals.

Examine portfolio concentration and turnover ratios. Higher turnover isn’t necessarily bad for momentum funds, but excessive trading can erode returns through transaction costs.

Review the fund manager’s experience with momentum strategies and their ability to adapt the approach based on changing market dynamics. 

To sum up 

Momentum funds offer a systematic way to participate in market trends by investing in stocks that are already performing well. They can generate strong returns during trending markets but require careful position sizing due to their inherent volatility.

Consider using momentum funds as a satellite allocation within a diversified portfolio rather than as your primary investment vehicle. Start with a small allocation  perhaps 10-15% of your equity portfolio  to understand how the strategy behaves across different market conditions. This approach lets you capture the benefits of momentum investing while managing the associated risks through proper diversification.