Does momentum investing make sense in MF portfolios?

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The past year has been extremely successful for practitioners of momentum investing. Simply put, this is a strategy that buys stocks that have done well in the recent past in the hope that the trend will continue.

There are different variants and different indices tracking momentum investing. For instance, the Nifty Alpha 50 Index picks stocks with the highest alpha over the past year—alpha being excess return over the market after adjusting for a stock’s sensitivity to the market (beta). Another index, the Nifty 200 Momentum 30, picks the stocks that have risen the most in the Nifty 200 over the past six months and one year after adjusting for volatility as measured by standard deviation. Both indices have done well over the past year with the Nifty Alpha 50 up 126.26% (as of 31 May) and the Nifty 200 Momentum 30 up 68.95%. The Nifty 50 itself was up 64.43% over the same period.

Alternatives to mutual funds such as smallcase also feature momentum strategies. For instance, the Capital Mind Momentum Portfolio on smallcase has given around 60% CAGR (compounded annual growth rate) since its launch in January 2019.

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A blog post published by Capital Mind on 10 December 2019 delved into the past returns of momentum investing using historical data from India markets. It outlined a simple momentum strategy and back-tested it before considering more complex variants.

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Paras Jain/Mint

“On the first trading day of the month, we rank all stocks based on their absolute return over the last 52 weeks (1 year). Buy the top 30 stocks in equal weight from this list. Rebalance every month,” the post stated. “ 100 in Jan 2007 in a simple 30-stock monthly rebalance momentum strategy would be 464 today. The same amount in the Nifty and the Nifty 500 would be close to 300. This translates to an annual return of 12.6% from momentum, while the Nifty and Nifty 500 did 8.9% and 8.7% respectively,” it found.

The momentum strategy, however, flies in the face of the efficient markets hypothesis—a theory that suggests markets immediately factor in all publicly available information into a stock’s price.

However, Deepak Shenoy, founder and chief executive officer (CEO) of Capital Mind, does not set much store by the theory. “We think markets are efficient, they are not. There is always information arbitrage—some people will have information before others, and those before even others, etc., which explains why stocks trend,” said Shenoy.

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On the flip side, momentum investing carries greater risk and for that reason has largely been a fringe concept in India’s mutual fund industry. The strategy underperforms when the market cycle changes such as a sharp drop or a sharp recovery “This is not a strategy for the faint-hearted. Momentum underperforms markets by a distance when markets correct sharply,” the Capital Mint blog post added.

Other experts feel that momentum investing works in certain phases of the stock market and not others. “I think momentum as a strategy works when market valuations are low. Let’s say a momentum strategy at 7,500 Nifty makes more sense than at 15,000. Value strategy works the best at high market valuations,” said Kirtan Shah, co-founder and CEO, SRE Wealth.

Rushabh Desai, a Mumbai-based mutual fund distributor, added, “There are two types of momentum strategies—earnings momentum which buys companies delivering consistent and high earnings with high ROE (return on equity) and price momentum which buys companies based on certain momentum ratios of high price returns. Earnings momentum is practised by some schemes such as Motilal Oswal Flexicap Fund and these can be the core of an MF portfolio. Price momentum, however, is riskier and should not be practised for mid- and small-caps. Within large caps, however, a price momentum strategy can be a satellite strategy in your portfolio (10-15% of your allocation).”

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