What Are Momentum Funds?

Different investment strategies aim to capture different kinds of opportunities. Some focus on value, hunting for undervalued companies. Others follow growth, targeting companies with rising earnings potential. Momentum investing takes a different approach. It seeks to capitalise on stocks that are already performing well. The idea is simple but powerful: securities that have been going up in price recently are more likely to continue their upward trend for a while, and those that have been falling may continue to drop.

Momentum funds are built entirely on this principle. In recent years, Indian investors have shown growing interest in momentum ETFs and momentum mutual funds as a way to diversify beyond traditional index or market-cap weighted strategies. With the rise of rule-based investing and smart-beta products, momentum strategies are now more accessible, transparent, and data-driven than ever before. Let’s find out more about them.

Defination Of Momentum Funds

Momentum funds are a type of equity or ETF investment strategy that focuses on buying stocks that have shown strong recent price performance over a certain period, typically 3 to 12 months. The underlying idea is that stocks that are already performing well are likely to continue doing well in the near future. This approach is grounded in the concept of momentum investing, which is widely researched in behavioural finance and market studies.

For example, if a particular set of stocks in the Nifty 200 index have risen consistently over the past six months, a momentum mutual fund might allocate more capital to those stocks. The selection is not random; it is based on quantitative rules that evaluate recent performance and other related metrics.

Momentum funds can be actively managed by fund managers or passively managed by tracking a momentum-based index, such as the Nifty 200 Momentum 30 Index. In India, both approaches are available, and they have been gaining popularity among investors seeking tactical strategies beyond plain, vanilla, index funds.

How Do They Work

Momentum funds operate using a clear, rules-based approach to selecting and replacing stocks in their portfolio. The process usually involves:

• Identifying Top Performers

  Using data like past returns over different timeframes (3, 6, or 12 months), trading volumes, and volatility levels, the fund manager or index algorithm ranks stocks from best to worst.

• Dynamic Portfolio Management

  Momentum funds do not hold the same stocks indefinitely. Portfolios are rebalanced periodically, often quarterly or semi-annually, to ensure they continue to hold the strongest performers.
  Example: If a stock that was in the top 30 performers falls to rank 50 after a quarter, it is likely to be replaced with a new high-ranking stock.

• Active vs. Passive Approaches

  • Active momentum mutual funds use the manager’s discretion to tweak selections and weightings based on market conditions.
  • Momentum ETFs usually follow a set index, with no individual stock-picking, making them more predictable but less flexible.

How Is Momentum Measured and Selected

Momentum funds do not pick stocks randomly. The selection process in momentum investing is almost entirely data-driven, and the most common metrics include:

• Price Performance: Percentage gain over the last 3, 6, or 12 months. In a momentum strategy, a stock with a greater price rise would score higher.
• Trading Volume: High trading volume during a price rise suggests that many investors are interested in the stock, making the trend stronger and more reliable.
• Relative Strength Index (RSI): The RSI is a technical indicator that measures whether a stock is overbought or oversold. In momentum investing, stocks with strong but not overly high RSI values can be attractive.
• PEG Ratio and Earnings Trends: The PEG ratio helps compare a stock’s price to its expected earnings growth. Momentum funds may use this to find stocks with strong price moves that are also backed by good growth expectations.
• Volatility Measures: Ensures that extreme short-term spikes are filtered out.

Example:
Suppose a momentum index like Nifty 200 Momentum 30 ranks all 200 companies based on their 6-month and 12-month price returns. A scoring formula might assign 60% weight to the 6-month return and 40% to the 12-month return. The top 30 companies by weighted score are then included in the index, and each is given a proportional weight.

This method creates a disciplined, repeatable process that avoids emotional decision-making.

Types Of Momentum Funds

Momentum investing comes in several flavours, depending on scope and execution style:

• Broad-Market Momentum Funds

  Invest across multiple sectors and market caps, tracking a wide momentum index such as Nifty 200 Momentum 30.

• Sector-Specific Momentum Funds

  Focus on trends within a single sector, such as IT, pharmaceuticals, or banking.

• Smart-Beta or Index-Based Momentum Funds

  Use rule-based algorithms to mimic momentum strategies without active management. Example: Momentum ETFs listed on NSE that track pre-defined momentum indices.

• Mutual Funds vs. ETFs

  • Momentum Mutual Funds: Suitable for SIP investors, no demat account needed, slightly higher costs due to active management.
  • Momentum ETFs: Lower expense ratios, can be traded intraday, require a demat account.

Benefits Of Momentum Funds

Momentum funds can be appealing to certain investor profiles for several reasons:

• Potential for Higher Returns in Bull Markets

  Since they invest in stocks already on an upward trajectory, momentum funds can outperform during strong market rallies.
  Example: In a year when the Nifty 50 grows by 12%, a well-executed momentum ETF might deliver 16%–18% due to its focus on high-growth stocks.

• Rule-Based Discipline

  By relying on quantifiable criteria rather than gut feeling, momentum funds reduce emotional biases like fear or greed.

• Diversification from Market-Cap Strategies

  Market-cap weighted funds lean heavily on large-cap companies. Momentum funds can capture opportunities in mid-caps or small-caps showing strong performance trends.

• Dynamic Adaptability

  Since portfolios are regularly rebalanced, the fund adapts quickly to changing market leaders.

Risks and Considerations

While the potential upside is attractive, momentum funds come with notable risks:

• Higher Volatility: Stocks with strong recent performance can also fall sharply during market reversals.
• High Turnover Costs: Frequent rebalancing can increase expense ratios and lead to higher short-term capital gains tax.
• Poor Performance in Flat or Bearish Markets: Momentum strategies work best when there are clear trends. In sideways markets, they may lag behind.
• Liquidity Concerns: If the strategy includes thinly traded mid-caps, selling positions in a downturn can be challenging.

Who Should Consider Momentum Funds?

Momentum funds are best suited for:

• Investors with a medium-term horizon of at least 3–5 years.
• Those comfortable with higher volatility in pursuit of potential outperformance.
• Individuals looking to diversify beyond core index funds.
• Investors using a satellite portfolio approach, allocating 10–20% to thematic or tactical strategies like momentum.

Risk-averse investors or those nearing retirement who prioritise capital preservation should consider all factors carefully before investing.

Conclusion

Momentum funds offer a compelling, rules-based way to ride strong trends in the market. They can deliver superior returns during bullish phases but may underperform in sideways or declining markets. 

Before investing, you should match momentum funds to your own risk tolerance. Since they tend to be more volatile than traditional index funds, they may not suit highly conservative investors. Monitor expense ratios carefully, as higher turnover can lead to increased fund costs and impact net returns. 

Finally, compare performance trends over multiple timeframes, not just the latest quarter, to ensure the fund’s approach aligns with your market outlook and investment horizon. When used wisely, momentum mutual funds or momentum ETFs can add an extra performance dimension and diversification to your portfolio.

Additional Reads: Different Types of Mutual Funds Scheme in India