What are Momentum Funds?

What are Momentum Funds?

Momentum funds have gained wider visibility among Indian investors as interest in factor-based equity funds and quantitative investing mutual funds grows. These funds follow a systematic, data-driven model that identifies stocks showing strong recent performance trends. Instead of relying on subjective judgement, momentum funds use predefined rules to build an equity momentum portfolio that aligns with prevailing market behaviour. This makes them an important part of the broader universe of SEBI categories of factor funds, where strategies are built around measurable investment factors such as value, quality, low volatility, and momentum.

Momentum Funds Explained

In simple terms, momentum funds invest in stocks that have displayed strength in recent periods, expecting these stocks to continue their performance for some time. This approach is inspired by the market observation that stocks with positive price trends often maintain that trend until it reverses. As a result, the momentum-based investing approach focuses on participating in established price movements instead of predicting potential reversals.

Momentum investing is different from traditional growth or value strategies because it does not emphasise valuations, long-term earnings prospects, or balance sheet strength. Instead, it revolves around high-performing stock momentum, where stocks demonstrating upward price trends receive higher allocation within the portfolio.

How Momentum Investing Works

Momentum funds rely on rule-based models and quantitative screening. These models assess stock performance across various timeframes, such as three-month, six-month, or twelve-month price movements. Once the strongest performing stocks are identified based on these metrics, the portfolio is constructed and managed accordingly.

Rebalancing is a crucial component of momentum fund investment strategy. Since market conditions and stock trends change frequently, many funds review their portfolio monthly or quarterly. This short-term trend-following strategy ensures alignment with the latest price trends and reduces exposure to stocks whose momentum has faded.

In India, many mutual funds track the Nifty 200 Momentum 30 Index or similar indices under the category of momentum index funds in India. These index-based schemes follow a passive or quasi-passive approach, enabling lower costs and higher consistency in replicating the underlying trend-based methodology.

Benefits of Momentum Mutual Funds

Momentum funds are designed to capture market trends efficiently. When markets exhibit directional clarity, these funds may help investors participate in ongoing trends without actively managing their portfolios. The strategy may also provide diversification benefits because it avoids concentrated exposure to sectors that are not performing well. Additionally, the systematic and model-driven nature of the strategy removes discretionary biases, which is a significant advantage for investors who prefer data-backed approaches.

Another potential benefit lies in their ability to complement traditional portfolios. Since momentum behaves differently from other factors, it can serve as a diversification tool within a multi-factor or blended strategy. Many investors use momentum funds to enhance the tactical allocation portion of their portfolios, especially during trending phases.

Risk-Return Profile of Momentum Funds

Even though momentum funds serve a specific purpose, they carry their own set of risks. The risk-return profile of momentum funds is shaped by market phases, rebalancing frequency, trend durability, and transaction costs.

One of the most discussed elements is volatility in the momentum factor. Since these funds chase established trends, they often enter stocks that have already experienced strong price movements. If the broader market reverses, these stocks may see sharper corrections than diversified baskets. Such reversals lead to drawdowns in momentum investing, which can be more noticeable during sudden market shocks or when trend patterns weaken.

Momentum strategies may also experience periods of underperformance when markets trade sideways, as the strategy relies on price dispersion and directional movements to function effectively.

Historical Performance of Momentum Strategy

International markets have observed the momentum factor for decades, and several academic studies highlight its consistency across different geographies. In the Indian context, the historical performance of momentum strategy has shown varying outcomes depending on market cycles. Momentum tends to perform relatively better during trending phases and may underperform in choppy environments. Past performance does not predict future results, but it offers insights into behavioural patterns associated with this factor.

Risks of Momentum Investing

Investors must understand the inherent risks of momentum investing before adding such funds to their portfolios. These include:

• Reversal risk – Trends may reverse unexpectedly.
• High volatility – Momentum stocks can react more strongly to news or corrections.
• Frequent rebalancing – This may lead to higher portfolio turnover.
• Dependence on market conditions – The strategy benefits from strong trends and may lag in muted markets.

Understanding these risks helps maintain realistic expectations while evaluating the suitability of momentum funds.

Should You Invest in Momentum Funds?

Momentum funds may be suitable for investors who prefer a systematic and rule-based approach over discretionary stock selection. They may appeal to those seeking exposure to market trends without actively timing the market. However, these funds might not suit conservative investors due to their sensitivity to market movements. Assessing your risk appetite, investment horizon, and portfolio objectives becomes essential before committing to such strategies.

Investors with a medium-term horizon and interest in modern portfolio concepts often consider these schemes as part of a diversified equity allocation.

Momentum Fund Taxation in India

As momentum funds fall under the category of equity-oriented schemes, they follow standard momentum fund taxation in India:

• Short-term gains (less than one year) are taxed at 15%.
• Long-term gains above ₹1 lakh in a financial year attract 10% tax.

Taxation clarity helps investors estimate potential post-tax returns and plan long-term allocations.

Conclusion

Momentum funds bring a structured, quantitative method to trend-based investing. By focusing on stocks with strong recent performance, these funds follow a disciplined process to capture market trends. However, investors must consider risks such as volatility, reversals, and reliance on sustained trends. For those who appreciate a data-driven approach and wish to explore market trend investing strategy, momentum funds offer an option worth evaluating within the broader framework of factor-based investing.

Frequently Asked Questions (FAQs):  What are Momentum Funds?

1. What are momentum funds in simple terms?

Momentum funds are mutual funds that invest in stocks showing strong recent performance, with the expectation that the trend will continue in the short to medium term.

2. How do momentum funds work?

They follow a rule-based strategy where stocks are selected based on factors like recent price trends, returns over specific periods, and market strength indicators.

3. Are momentum funds safe to invest in?

They are not risk-free. Momentum funds can be volatile because they chase trends, and returns may fluctuate based on market conditions.

4. Who should invest in momentum funds?

Investors with a higher risk appetite, a shorter-to-medium time horizon, and an interest in quantitative strategies may consider them.

5. What is the ideal investment horizon for momentum funds?

Typically 3–5 years, since short-term market movements can affect performance.

6. Do momentum funds perform well in all market conditions?

No. They tend to perform better during bull markets or trending phases and may underperform during sideways or highly volatile markets.

7. Are momentum funds suitable for beginners?

Beginners can invest, but only if they understand the risks. These funds may not offer stable returns like large-cap or hybrid funds.

8. What is the tax treatment of momentum mutual funds in India?

Momentum funds are equity-oriented, so equity mutual fund taxation applies:

• LTCG (above ₹1 lakh): 10%
• STCG: 15%

9. What is the difference between momentum funds and value funds?

Momentum funds chase winning stocks, while value funds invest in undervalued stocks that may rise in the future.

10. How often do momentum funds rebalance their portfolio?

Most rebalance monthly or quarterly to adjust to new market trends.

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Disclaimer: This blog post is intended for informational purposes only and should not be considered financial advice. The financial data presented is subject to change over time, and the securities mentioned are examples only and do not constitute investment recommendations. Always conduct thorough research and consult with a qualified financial advisor before making any investment decisions.