Momentum Trading: Everything You Need To Know

Did you know that the momentum strategies reported greater than Index Fund returns for the Indian stock markets for the past decade and more?

Backtested data suggests some strategies have outperformed the index funds by more than 50% and some even by 100%.

However, it has also introduced dramatic drawdowns for its supposed investors. So the returns do come at the cost of higher volatility.

Let's explore this approach to trading in detail.

What Is Momentum Trading All About?

In 1993 two researchers, Jagadeesh and Titman published a research paper titled "Returns to Buying Winner and Selling Losers: Implications for stock market efficiency" the paper showed that stocks that have performed well in the recent past tend to continue to perform well in the near future as well.

Their research has contributed to the understanding of Momentum Trading and helped establish it as a legitimate investment strategy.

Momentum Trading involves buying stocks with strong recent performance and selling or exiting those that have underperformed based on the expectation that the momentum will continue.

Examples Of How Momentum Trading Works

Read on to understand how a Momentum portfolio is constructed.

Step 1 - Define a universe

First things first, you need to define a universe of stocks, you can keep all the listed stocks on an exchange as your universe for stock selection, or you can choose a smaller subset of stocks, say something like the NSE500, which includes the top 500 stocks based on market capitalization.

Let’s say we choose to go with NSE500 as the universe.

Step 2 - Momentum filters

What does this even mean? Well, you can't just select all the stocks of the NSE500, which will make it similar to trading in the index fund. You have to select some top stocks, say twenty stocks, from the top five hundred to make your momentum portfolio

To shortlist the stocks in your portfolio, you can rely on some well-known strategies, like,

1. Relative Momentum
2. Absolute Momentum
3. Dual Momentum.

Each strategy follows certain rules (as explained below) while constructing your portfolio.

For example, in Relative Momentum Trading, you will have to select 20 stocks in your universe which have performed relatively the best in your selected time frame (it can be a quarter, half-yearly or even yearly).

Step 3 - Rebalancing

Supposedly, if the performance of one of the 20 stocks drops or the performance of the other stocks in your universe improves, then you will have to rebalance your portfolio.

So you will replace the poorly performing stock in your portfolio with a new stock performing well in the universe of NSE500. This is known as holding the winners in your portfolio and selling the losers.

Rebalancing is a critical aspect of Momentum Trading, and the frequency of rebalancing can have a significant impact on the performance of the investment strategy.

If you rebalance too often, you may end up buying and selling stocks too frequently, leading to increased transaction costs and reduced returns. If you rebalance too infrequently, you may end up holding onto stocks that have lost momentum, leading to underperformance.

The optimal rebalancing frequency will depend on the specific momentum strategy being used, the market conditions, and the investor's risk tolerance. Typically, momentum strategies are rebalanced on a monthly or quarterly basis, but some investors may prefer to rebalance more or less frequently based on their preferences.

Types Of Momentum Trading Strategies?

We can define the above-mentioned types of Momentum Trading as described below.

• Relative Momentum Strategy

Usually when the term Momentum Trading is used, it largely refers to “Relative Momentum” which is the most generic form of Momentum Trading and largely adopted. In this strategy, the momentum of stocks is evaluated by comparing them. The stocks with the strongest performance over a specified time frame, such as a year, are preferred, and the weakest performers are not considered.

Studies have demonstrated that intermediate-term momentum, which spans from 3 to 12 months, is the most effective.

• Absolute Momentum Strategy

This strategy utilizes the stock's past performance to gauge investors' likelihood of trading. So if the performance of Adani Green has been positive for the past 1 Year, you are likely to stay invested in the stock, thus bringing more investors to this company.

The performance can be analyzed by using the moving average as one of the indicators to compare the current price with the stock's historical prices.

• Dual Momentum

Dual momentum is a combination of relative and absolute momentum. A dual momentum approach seeks out stocks that exhibit both positive absolute and relative momentum while avoiding those that exhibit negative momentum in both respects.

A well-referenced research paper by Gary Antonacci, titled “ Risk Premia Harvesting Through Dual Momentum,” compares all of them and explains them in an easy-to-understand manner.

The paper shows that Dual Momentum can significantly improve performance in asset classes, including equities. This approach helps reduce the downside risk and enhances expected returns while providing diversification and flexibility.

How Has Momentum Performed Across The Years?

As mentioned above, In India, multiple SEBI-Research analyst-managed PMSes and Mutual funds incorporate Momentum Strategy.

Let us consider the performance of UTI’s NIFTY 200 Momentum 30 Index, which invests in the top 30 companies within the NIFTY 200 index. This portfolio uses the concept of relative momentum, where it invests in the top 30 companies based on the” Normalized Momentum Score.”

According to a Nifty200 Momentum 30 white paper, the historical performance of this momentum index has always outperformed the NIfty 200 Index.

Source: NSE Indices. Data as of August 31, 2020

Since its inception, the momentum index has given a CAGR of 18.6%, while the NIFTY 200 index itself gave a return of 12.7%.

However, the momentum index also brings in some natural volatility and is hence often considered to be a riskier asset.

The Nifty200 Momentum 30 Index has been slightly less volatile than the Nifty 200 Index over recent short-term horizons but somewhat more volatile over long-term horizons.

The volatility of the markets: Volatility can be described as a measure of change. Higher the volatility higher the change. In the case of the stock market, volatility indicates a stock whose value changes significantly.

Source: NSE Indices. Data as of August 31, 2020. Inception date: April 01, 2005. Returns based on TRI values

Note:

1. The strategy can be unique to every portfolio, depending on the quantitative indicators chosen to devise the strategy. More on it is below.
2. Return-Risk Ratio is better than the NIFTY 200 Index, stating the momentum portfolio has a higher return to the comparative risk when compared to the NIFTY 200 Index

Due to the high volatility and its partnered risks, these strategies have also resulted in greater investors' losses in the event of serious market corrections. To limit the drawdowns, the portfolio undergoes rebalancing every 6 months.

Source: NSE Indices

The above shows the evolution of sector weights over time. On December 31, 2017, the Automobile sector represented 17.1% of the index, but the sector was removed by the end of 2018 and 2019. During the last five years, the Index has maintained some exposure to the Consumer Goods and Financial Services sectors. However, the weights for these sectors fluctuated greatly during that time.

Drawdowns: Drawdowns are a measure of a drop in value from the peak of stock to the lowest of its value. Consider an example of the Vodaphone. So if an investor had bought Vodafone at ₹75, which later peaked at ₹110, and the investor sold it for ₹80, the drawdown here is ₹30.

Ways To Invest In A Momentum Trading Strategy?

Some popular ways to invest in Momentum Strategies are through funds managed by SEBI-registered research analysts. Some of them are,

• Mutual Fund (MF):

A mutual fund is a fund professionally managing money from many investors to purchase stocks according to the strategy of the said Mutual fund. One of the most popular MFs is the UTI Nifty200 Momentum 30 Index Fund.

• Portfolio Managed Services (PMS)/Alternative Investment Funds (AMS):

Companies provide PMS for high-net-worth individuals comfortable taking additional risks for potentially better returns than the market. The minimum investment requirement for these services is 50 Lakhs.

AIFs are pools of funds from multiple investors which focus on trading in alternative asset classes like private equity, real estate, etc. The minimum investment requirement for these services is 1 crore.

• Research Analysts (RA) led Baskets:

Certain RAs use their years of knowledge to create baskets of stocks selected based on the strategy chosen. Investors can invest in those baskets and share the profits, if any.

You should consider understanding our own “Sector-Superstars” and “Buy high sell higher” Momentum-based strategies, managed by SEBI registered analysts. Our “Sector Superstars” have recorded a CAGR of >21% since 2019.

• Build Your Own Momentum Portfolio:

You can also build your Momentum Portfolio, which can be a rewarding experience. However, you should understand the market well, the importance of diversification &  careful research, and you also should possess the technical know-how to analyze the stocks.

Should Momentum Trading Be A Part Of Your Investments?

Here are some key points you should consider for making the decision.

• Since it is a riskier form of trading, it is generally preferred by more risky investors affording short-term loss if any.
• Momentum Trading has the potential to outperform the market in the short-term & long term, which can result in higher returns for investors.
• Momentum Trading is often based on straightforward technical or fundamental analysis, making it easier for investors to understand and execute.
• Momentum Trading can complement other investment strategies, providing a diversified investment portfolio.
• Carefully vetted momentum portfolios have often beaten the indexes and thus give you good investment returns.

Summary

There is no universally accepted answer to this strategy's percentage allocation of your funds. This decision is governed by a variety of factors, such as your investment goals, risk tolerance, and overall financial situation. Some investors allocate a portion of their portfolio to Momentum Trading strategies, while others follow a different investment approach.

Ultimately, the percentage of your portfolio you allocate to Momentum Trading should align with your overall investment strategy and help you meet your financial goals.

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