Choice of momentum factor index should depend on performance in downturns

Momentum investing is gaining in popularity, with asset management companies (AMCs) now offering various such index funds. A new Nifty 500 Momentum 50 index fund was launched recently, adding to the existing Nifty 200 Momentum 30 and Nifty Midcap 150 Momentum 50 funds. The success of these funds underscores AMCs’ confidence in momentum products.

 

Why momentum investing?

 

Momentum investors believe that stocks with recent price gains are likely to continue rising. This approach contrasts with the conventional “buy low, sell high” strategies. Momentum investing instead advocates “buy high, sell higher”. In a momentum index, stocks are selected based on recent performance.

 

Some examples:

 

• Nifty 200 Momentum 30 selects 30 stocks with the highest momentum scores from the Nifty 200 universe.

 

• Nifty Midcap 150 Momentum 50 picks 50 momentum stocks from Nifty Midcap 150.

 

• Nifty 500 Momentum 50 takes the top 50 momentum stocks from the Nifty 500.

 

Constructing an index requires a clear definition of “momentum”. Nifty Indices, for instance, evaluates price performance over six and 12 months, adjusted for volatility. Thus, this approach favours stocks with steady price increases. It reduces the weight of more volatile stocks and creates a momentum portfolio that is likely to progress more smoothly.

 

Evaluating factor index products

 

When AMCs launch a new factor index fund, it usually comes with strong back-tested data. If a factor index underperformed in the past, it’s unlikely it would attract interest from AMCs or investors.

 

Keep in mind, however, that past performance does not guarantee future results. High returns in back tests might not always persist once a fund is launched. For instance, the Nifty Midcap 150 Momentum 50 index shows an impressive 7 per cent alpha (excess return) over Nifty Midcap 150 in back tests over 15 years (data is for April 1, 2005 to August 31, 2024). Yet, as substantial investments flow in, this alpha might shrink or even vanish. To expect sustained alpha of 7-10 percentage per annum over parent benchmarks would be unrealistic. 

 

Any factor strategy will also underperform at times. It’s essential to consider this possibility when deciding how much to invest. No strategy performs well consistently; periods of underperformance are common and even necessary for long-term gains. 

 

Conviction in strategy essential

 

Investing in a factor index fund requires confidence in the strategy. Frequent buying and selling based on short-term performance can lead to poor timing and reduced returns. Remember, actual investor returns will differ from the returns produced by an investment if the investor engages in frequent buying and selling.

 

Furthermore, consider liquidity before going for a broader stock universe. Smaller stocks may lack the liquidity of large caps. While index providers attempt to balance allocations, liquidity issues can affect performance.

 

Which momentum index to choose

 

Before choosing a momentum index, decide if momentum investing aligns with your strategy. If it does, consider your allocation carefully. Diversify your portfolio instead of investing solely in momentum funds.

 

With three factor indices and multiple funds following the momentum approach, your choice should be informed by your risk tolerance and investment acumen. Personally, I recommend examining how each index performed during challenging market phases. An index with less volatility during downturns can help you remain invested, a vital factor in long-term success.

 

The writer is a Sebi-registered investment advisor