Understand How Momentum Strategy Captures the Trend in Volatile Markets

In the world of investing, momentum is a powerful force. Momentum investing is all about spotting winners and riding their waves of success. The concept revolves around the momentum factor, which captures the idea that stocks which have done well recently will tend to keep outperforming, at least for a while.

Think of it like this: You’re more likely to watch a movie by a director who’s delivered consecutive hits than someone whose recent films have flopped. Similarly, even the momentum strategies focus on identifying top-performing stocks and then leveraging their continued upward trend.

The Philosophy of Momentum: Persistence Pays

Momentum falls under the category of “persistence factors”. It thrives on the idea that trends in the market often persist for a period before reversing. Simply said it doesn’t ask “why” a stock is climbing; it simply bets that the climb will continue.

Unlike the traditional investing approaches, momentum investing does not get into a company’s fundamentals. It won’t analyse earnings, revenue growth, or balance sheets. Instead, it zeroes in on the stock prices, adhering to its principle of 'buy high and sell higher.' It may be influenced by investor sentiments, some macroeconomic factors, or even sectoral shifts. And this is what makes momentum investing particularly powerful in volatile markets. As trends may emerge more clearly during times of uncertainty, this offers opportunities for momentum investors to act quickly on.

How the Momentum Index Works?

Momentum strategies are systematic and data-driven. This is done by evaluating their risk-adjusted returns over specific periods, like the past 6 months and 12 months. Typically, in momentum indices, stocks are ranked by their recent price performances. The ones at the top of this list make it into the portfolio.

This focus on price means momentum portfolios need frequent updates. Typically, they are then rebalanced semi-annually. This keeps the portfolio aligned with the latest market trends. This may also result in higher churn and transaction costs. But, that’s the price you pay for staying in sync with the market’s pulse.

Behavioural Biases and Why Momentum Works

Momentum strategies succeed because markets aren’t perfectly rational. Investors often act irrationally. And, then because of these behavioural biases in markets leading to more inefficiencies which create opportunities for momentum strategies to capitalize on.

In volatile markets, where emotions often run high, such biases are magnified. Momentum strategies thrive in these conditions, capitalizing on the mispricing created by investor overreactions and under reactions. For example,
• Under reaction to News: Investors don’t always respond immediately to positive news. A stock may see its price climb steadily over time, creating an opportunity for momentum investors.
• Herding Behaviour: When investors follow the crowd, they amplify price movements. This creates trends that momentum strategies can capitalize on.

A Dynamic and Adaptive Factor

Momentum is one of the most flexible investment strategies. It adapts quickly to the latest market trends, whether in terms of size, sector, or style.

For example, during a tech boom, momentum portfolios may heavily feature technology stocks. If the market focus shifts to energy or defensive sectors, momentum strategies realign to reflect these changes. This adaptability ensures relevance across varying market cycles. However, it also makes momentum one of the highest-turnover strategies. Frequent rebalancing is essential to keep pace with emerging trends.

Momentum in Volatile Markets

Volatile markets can be intimidating, but they’re also ripe with opportunities for momentum investors. Trends often become more apparent during periods of market turbulence, making it easier for momentum strategies to identify winners.

When markets rally, momentum strategies focus on the top-performing stocks driving the uptrend. Conversely, during downturns, they shift to sectors or stocks showing resilience. This ability to pivot between market phases gives momentum a unique edge, particularly in unpredictable environments.

Conclusion

Momentum investing is a testament to the power of trends and investor psychology. While it doesn’t guarantee immunity from downturns, its adaptability and reliance on human psychology make it a compelling tool for capitalizing on fleeting opportunities.

However, as with any strategy, it’s essential to understand its nuances. Momentum may perhaps work as part of a diversified portfolio, complementing other investment styles. While it may not suit every investor, its ability to adapt to shifting market dynamics makes it a valuable tool for those looking to capture opportunities in an ever-changing landscape.

Disclaimers:

This document represents the views of Axis Asset Management Co. Ltd. and must not be taken as the basis for an investment decision. Neither Axis Mutual Fund, Axis Mutual Fund Trustee Limited nor Axis Asset Management Company Limited, its Directors or associates, shall be liable for any damages including lost revenue or lost profits that may arise from the use of the information contained herein. No representation or warranty is made as to the accuracy, completeness or fairness of the information and opinions contained herein. The material is prepared for general communication and should not be treated as a research report. The data used in this material is obtained by Axis AMC from the sources which it considers reliable. While utmost care has been exercised while preparing this document, Axis AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The AMC reserves the right to make modifications and alterations to this statement as may be required from time to time.

Axis Bank Ltd. is not liable or responsible for any loss or shortfall resulting from the operation of the scheme.

Mutual Fund Investments are subject to market risks, read all scheme-related documents carefully.