Understanding Momentum Investing and Its Benefits

Momentum investing is a strategy that focuses on buying stocks or assets that have been performing well recently, with the idea that they will continue to do so in the future. This approach is based on the concept that past performance is a strong indicator of future success.

The momentum investing strategy was first popularized by hedge fund manager Peter Lynch, who used it to achieve impressive returns in the 1970s and 1980s. His approach involved identifying stocks with high price momentum and holding onto them for a relatively long period of time.

By focusing on momentum, investors can potentially avoid the pitfalls of value investing, where stocks may appear cheap but have little chance of recovering. As seen in the article, the S&P 500 index has historically outperformed value stocks over the long term, making momentum a more attractive option for many investors.

In practice, momentum investing involves using technical indicators such as moving averages and relative strength index (RSI) to identify stocks with strong momentum.

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Momentum investing is a strategy that focuses on identifying stocks or assets that are currently performing well and have a high likelihood of continuing to do so in the future.

Research has shown that stocks that have recently experienced high returns tend to continue performing well, with one study finding that the top 10% of stocks by performance over the past year were more likely to continue outperforming the market.

In fact, a study of the S&P 500 found that the top 20% of stocks by performance over the past year were more likely to end up in the top 20% of the market over the next year.

Momentum investing is based on the idea that past performance can be a strong indicator of future success, and that by identifying stocks that are currently on a roll, investors can potentially ride the momentum and earn higher returns.

However, it's worth noting that momentum investing can be a high-risk strategy, as it relies on the continuation of a trend that may eventually reverse.

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Momentum investing is a strategy that relies on the idea that past performance can be a good indicator of future success.

Momentum is the rate of change of return and can be measured across any time frame. This means you can look at a stock's performance over a short period, like a week, or a longer period, like a year.

To create a momentum portfolio, you need to carefully select the stocks that have shown the highest momentum over a specific time frame. A good tracking universe to use is the BSE 500.

Once you have your tracking universe, you need to calculate the returns for each stock and rank them from highest to lowest. The top 12 or 15 stocks with the highest returns become your momentum portfolio.

The expectation is that the momentum will continue during the holding period, so you're essentially betting that the stocks that have been performing well will keep doing so.

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You can also use fundamental data, such as growth in sales, EBITDA margins, EPS growth, and net profit margin, to measure momentum. This can be a useful alternative to price-based momentum.

Price-based momentum works best in an upward trending market, so it's not the best approach when the market is sideways or down trending.

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Building a momentum investing plan requires defining your stock universe, which can be a daunting task given the vast number of stocks available.

A good starting point is to use a straightforward tracking universe, such as the Nifty 50 or BSE 500 stocks. This will give you a manageable set of stocks to work with.

To create a more tailored tracking universe, you can use custom creation techniques, such as filtering out stocks with a market cap of at least 1000 Crs or a stock price of less than 2000.

Having at least 150-200 stocks in your tracking universe is a good rule of thumb if you want to build a momentum portfolio of 12-15 stocks.

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You can also use a sector-specific approach, identifying a sector that exhibits strong momentum and then looking for the stocks that display maximum strength in terms of momentum.

Momentum strategies can be developed on a single-stock basis, but using a sector-specific approach can provide a more diversified portfolio.

A momentum portfolio can be created by identifying the stocks that showcase the highest momentum across the tracking universe and trading them for the subsequent 6 months.

This approach involves shorting or selling the worst performers from the past 6 months for the next 6 months, and then buying back the stock to net off your position.

Shorting stocks is a technique where you first sell a stock and then after some time buy back the stock, thereby netting off your position.

Momentum can be applied on a portfolio basis, involving portfolio creation with a specific number of stocks, each showcasing momentum.

This approach offers safety in diversification and is an excellent strategy for building a momentum portfolio.

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Momentum investing has enjoyed a strong run globally for many years, with cracks only showing during major market downturns like 2000, 2008, and 2020.

The NIFTY 200 Momentum 30 index has consistently outperformed other popular indices in India, including the NIFTY 50, NIFTY Next 50, NIFTY Midcap 150, and the NIFTY 200.

In 7 out of 15 years, the NIFTY 200 Momentum 30 Index was the highest-performing index across all five indices.

The NIFTY 200 Momentum 30 Index has returned more than the NIFTY 50 in 10 years and has overpowered the NIFTY 200 in 12 years.

Here are some key statistics on the performance of the NIFTY 200 Momentum 30 Index:

Momentum investing has also been shown to deliver high returns in the long run, with studies suggesting that its effectiveness has not been compromised despite its growing popularity.

Momentum investing can be compared to other popular investment strategies, such as value investing and technical analysis.

Momentum investing tends to outperform value investing in the long run, according to research that showed a momentum strategy beating a value strategy by 4.4% annually over a 20-year period.

Value investing, on the other hand, focuses on finding undervalued stocks that have the potential for long-term growth. However, this strategy often requires a significant amount of time and research to identify these undervalued stocks.

Momentum investing is also different from technical analysis, which focuses on using charts and patterns to predict future price movements.

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Buy-and-Hold is a long-term investment strategy that focuses on stable growth over time.

The S&P BSE Sensex is a prime example of a buy-and-hold portfolio, representing a long-term, stable investment in large-cap stocks.

It's worth noting that the Sensex tends to have larger falls than the S&P BSE Momentum Index, but these falls are often consistent and predictable.

Over 3, 5, and 7-year periods, the Sensex has provided stable returns, but not necessarily outperforming the Momentum Index by large margins.

A true buy-and-hold portfolio, handpicked based on individual factors, can also outperform momentum strategies, making it a viable option for investors seeking stable growth.

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For mutual fund investors, momentum investing has proven to be a viable strategy, particularly with the Nifty200 Momentum 30 Index outperforming the Nifty 200 and Nifty 50 in 6 out of 11 quarters since its launch in 2020.

The Nifty200 Momentum 30 Index selects 30 stocks showing momentum from the Nifty 200, with an average quarterly return of 5.7%. It's essential to note that this fund's underperformance during down periods can be significant, such as a 19.5% drop in June 2022.

Another option is the Nifty Midcap 150 Momentum 50 Index, which has outperformed its parent index in 4 out of 6 quarters since its 2022 launch, averaging 8.6% in quarterly returns.

Two active funds, Samco Active Momentum Fund and Quant Momentum Fund, have delivered high short-term returns, with Samco Active Momentum Fund returning 27.90% since inception and Quant Momentum Fund returning 41.10% between November 20, 2023, and May 7, 2024.

However, it's crucial to wait before making substantial investments in these funds due to their limited performance history.

Sector rotation ETFs are a great way to apply momentum strategies to your investment portfolio. You can rotate between different sectors or asset classes based on their performance.

One example of sector rotation is the Nippon India Nifty Auto ETF, which invests in the auto sector and delivered a 16% return over the past three months. This is just one of the sectors that have shown impressive returns, along with metal and power.

To implement sector rotation, you can use ETFs like the Health Care Select Sector SPDR Fund (XLV) and the Technology Select Sector SPDR Fund (XLK). This involves buying the ETF that's performing well and selling when its performance drops.

Here are some examples of sector rotation momentum strategies:

The average gain per trade in sector rotation is 1.31%, with an annual return of 10.1% and a win rate of 58%. However, it's essential to remember that nothing lasts forever, and the world changes, so it's crucial to adapt and adjust your strategy accordingly.

Momentum investing can be a powerful strategy for investors, but it requires the right tools and techniques.

To build a momentum portfolio, you can use a systematic guide like the one mentioned in Example 3, which involves creating a tracking universe, calculating 12-month returns, ranking stocks, and rebalancing the portfolio at the end of each month.

The Nifty200 Momentum 30 Index has outperformed the Nifty 200 and Nifty 50 in 6 out of 11 quarters since its launch in 2020, with an average quarterly return of 5.7%.

Some popular momentum trading indicators include trend lines, moving averages, stochastic, Average Directional Index (ADX), and price action analysis. These indicators can help identify the momentum of an asset's price and make informed investment decisions.

Here are some key statistics for the sector rotation momentum strategy ETFs mentioned in Example 4:

To set up the data for momentum investing, you'll need to get the closing prices of all the stocks in your tracking universe. This data should be clean and adjusted for corporate actions like bonus issues, splits, and special dividends.

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There are plenty of data sources where you can download the data for free, including the NSE/BSE websites. You can also update this data daily, recording the daily closing prices.

For this strategy, you only need 1-year data points. For example, if today is 2 March 2019, you'd need data points from 1 March 2018 to 2 March 2019.

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Momentum investing is all about identifying stocks with high momentum, and there are several key indicators that can help you do just that. One of the most popular indicators is the trend line, which shows the direction of the trend. Stocks with steep uptrend lines are perfect for long positions, while those with steep downtrend lines are ideal for short positions.

Trend lines are drawn along successive swing points on a price chart, and the slope of the line shows the strength of the price momentum. For example, if you're looking at the auto sector, a steep uptrend line might indicate that it's a good time to buy stocks like Nippon India Nifty Auto ETF.

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Moving averages are another crucial indicator in momentum trading. They continuously calculate the price average as new data is printed, helping you identify the prevailing trend while eliminating small, insignificant price fluctuations. If a stock's price consistently remains at or above a moving average, it's a sign of an uptrend.

Stochastic is a momentum oscillator that compares an asset's most recent closing price to the prices over a chosen period of time. If the closing price is near the high of the price range, it indicates high momentum, and if it's near the low, it shows a downward trend. For instance, if you're using a 12-month portfolio, you can calculate the return and rank the stocks based on their monthly performance to see which ones are doing the best.

Here are some of the most commonly used momentum trading indicators:

These indicators can be used in various ways to identify high momentum stocks. For example, you can use trend lines to identify stocks with steep uptrend lines, or moving averages to see if a stock's price is consistently above or below its average price.

Using ETFs for Momentum Investing can be a great way to apply momentum strategies. You can use ETFs to rotate between assets or sectors based on their performance.

Momentum investing can also be applied to ETFs, and sector rotation is a popular strategy. For example, you can rotate capital between the Health Care Select Sector SPDR Fund (XLV) and the Technology Select Sector SPDR Fund (XLK).

To use ETFs for momentum investing, you can follow these basic steps: identify the ETFs you're interested in, check if they're trading close to or above their yearly highs, sort the chosen ETFs from highest to lowest based on momentum, and buy the best-performing three ETFs.

Here are some examples of sector rotation momentum strategies:

You can also use a monthly momentum strategy to determine which ETF to be long the next month. For example, you can rank all four ETFs (SPY, TLT, EFA, and EEM) every month based on last month's performance/momentum, and go long the one ETF with the best performance.

When buying and selling stocks, momentum traders often aim to buy high and sell higher, rather than the traditional "buy low and sell high" approach. This strategy involves identifying stocks that are on the rise and selling them at an even higher price.

Some traders attempt to use momentum trading strategies to make a profit. The popular stock trading adage "Buy low and sell high" is a fundamental principle of traditional investing, but momentum traders often try to defy this rule.

Momentum trading strategies can be found in one place, allowing traders to easily access and compare different approaches. Traders can use these strategies to make informed decisions about their investments.

The key to successful momentum trading is to identify stocks that are on the rise and sell them at an even higher price. This requires a deep understanding of market trends and a keen eye for opportunity.

By using momentum trading strategies, traders can potentially make a profit from stocks that are on the rise.

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Backtesting is a crucial step in evaluating the performance of a momentum trading strategy. The strategy has almost kept with buy and hold despite spending just 65% of the time in the market.

A price action momentum trading strategy backtested on the S&P 500 since 1960 until today resulted in 41 trades. The average gain per trade is 10%.

The strategy's CAGR (annual returns) is 5.7%, which is lower than the buy and hold strategy of 6.9%. The Win rate is 69%, and the Profit factor is 7.

A similar strategy backtested on the German DAX index had a CAGR of 7.2%, slightly below the buy and hold strategy of 7.9%. The strategy has been flat recently, but the DAX has yielded low returns over the last few years.

In contrast, a price action momentum strategy backtested on Bitcoin resulted in 179 trades with an average gain per trade of 2.35%. The CAGR is 55.7%, which is significantly higher than the buy and hold return of 58%.

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Here's a summary of the performance metrics for the three strategies:

These results demonstrate the importance of backtesting and evaluating a momentum trading strategy before implementing it.

A price-based momentum strategy can be a great way to earn returns, but it's essential to understand its limitations. This strategy performs poorly in choppy markets and can even lead to losses when the market is trending down.

The 2011 market downturn was a harsh lesson for the author, who saw their momentum portfolio take a significant hit. This highlights the importance of understanding the strategy's behavior in different market cycles.

To succeed with a momentum strategy, it's crucial to do your homework and backtest it thoroughly, as the author learned the hard way.

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Investors often overreact or under-react to information, leading to pricing inefficiencies and significant price movements.

A disorganized financial system can result from investors' reactions to news about the trading world.

Investors might take time to respond to fresh information, but once they realize its usefulness, they move in and cause momentum in the market.

Momentum in the market is usually short-term, lasting between 6 months to a year.

Investors initially react slowly to new information and then do a hurried follow-up, driving momentum.

This catchup nature is why momentum investing has always been a short-term strategy.

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A price-based momentum strategy can be a great way to make money in the market, but it's not foolproof.

The strategy performs poorly in choppy markets, and can even lose more money than the market itself when it's trending down.

I learned this the hard way in 2011, after having a great run with the strategy in 2009 and 2010.

It's crucial to understand how the strategy behaves in different market cycles to avoid a bad hit.

Backtesting is essential to do your homework before executing this strategy.

A price-based momentum strategy can still give you great returns, often better than the market returns, if implemented in the proper market cycle.

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