Momentum-based factor funds: Volatile but rewarding strategy for investors

New fund offers for index funds and exchange-traded funds (ETFs) based on the Nifty 500 Momentum 50 Index from Motilal Oswal and Nippon India are currently open. Factor funds, especially those following the momentum strategy, are gaining traction.

According to the “Where the Money Flows” report by Motilal Oswal Asset Management Company (AMC), factor funds saw net inflows of Rs 5,000 crore in the April-June quarter of 2024-25, with nearly half coming from momentum-based funds, which have performed well over the past year.

“Factor investing is growing rapidly in India. Among factor funds, momentum is the largest and the most popular strategy,” says Pratik Oswal, chief of business, passive funds, Motilal Oswal AMC.

 

How do they work?

A momentum-based factor index selects stocks from indices like Nifty 200 or Nifty 500, focusing on those showing the highest price growth over the past 6 or 12 months.

“Some momentum strategies do not rely solely on momentum but also consider alpha, while others go for stocks showing high volatility-adjusted returns,” says Arun Kumar, head of research, FundsIndia.

Momentum investing focuses on buying rising stocks. “It is the antithesis of value investing, where one picks stocks that are falling,” says Deepesh Raghaw, a Securities and Exchange Board of India (Sebi)-registered investment adviser (RIA).

Adaptive strategy

Momentum is an adaptive strategy, rotating into the parts of the market that are performing well—whether largecap, smallcap, quality, or value. “It is style, sector, and market cap agnostic,” says Oswal.

High-churn fund

Momentum funds can be 10-15 per cent more volatile than the Nifty 50. “During a market correction, the drawdown would be higher than in a Nifty 50 fund,” says Oswal.

These indices pick stocks based on recent performance without necessarily considering quality. “Towards the end of a bubble market, low-quality stocks tend to do well and can enter the portfolios of momentum funds. When the bubble bursts, these stocks take a significant hit,” says Kumar.

The strategy also involves high portfolio turnover. “Managing such a high-churn portfolio becomes challenging once the fund’s assets under management (AUM) grow large,” says Kumar. Moreover, a broad index like the Nifty 500 contains illiquid stocks, and large purchases may push up the average purchase price, negatively affecting returns.

While the momentum strategy has delivered in the past, similar performance may not get repeated. Moreover, these funds have limited live track records. “Funds based on specific indices are often launched when those indices show strong past returns. However, as money flows into the strategy, future returns can diverge significantly from back-tested results,” says Raghaw.

Should you invest?

Raghaw suggests investing in momentum funds only if you have conviction. This will help you stay invested during the inevitable periods of underperformance.

“Diversify your portfolio across five different styles— momentum, value, growth, quality, and mid- and small-cap— allocating 20 per cent to each,” says Kumar. If you follow this approach, momentum funds can form part of your core portfolio.

If your core portfolio is built around market cap-based indices like Nifty 50, consider including a momentum fund in your satellite portfolio, allocating 10-20 per cent of your total equity holding. Enter these funds with at least a seven-year horizon.