Which one do you like?

It has been raining factor index funds.

Recently, an AMC launched a Nifty 500 Momentum 50 index fund, the first on this index.

We already have two momentum index products in the markets. Nifty 200 Momentum 30 and Nifty Midcap 150 Momentum 50 index fund. And the momentum index funds have done well recently. Hence, I am not surprised to see the AMCs launching different variants of momentum products.

If you believe in momentum investing, which variant of momentum will you pick? You have atleast 3 choices of momentum indices now.

In this post, let’s see how these momentum factor indices have performed in the past.

Sharing the performance summary here. Will discuss in detail later.

How does Momentum investing work?

If you are a momentum investor, you believe the stocks that have risen in the recent past will keep on rising for some more time. The intent is to ride onto such stocks as long as they keep rising or until you can find better momentum stocks. 

This is in stark contrast to how many of us think about picking stocks.

Conventional investment approach (or the value approach) is Buy Low and Sell High.

Momentum investing is: Buy High and Sell Higher.

A momentum index picks the best momentum stocks from a universe of stocks.

For instance, Nifty 200 Momentum 30 index picks 30 stocks with highest momentum score from the universe of Nifty 200.

Nifty Midcap 150 Momentum 50 index picks 50 best momentum stocks from Nifty Midcap 150.

Similarly, Nifty 500 Momentum 50 picks top 50 momentum stocks from Nifty 500.

To construct a momentum index fund, we need a definition of momentum. And this definition can vary. For instance, NiftyIndices, among other things, considers price performance over the last 6 and 12 months. S&P, on the other hand, considers the performance of the last 12 months, excluding the most recent month. I have written about S&P methodology in an earlier post on momentum investing.

In Nifty momentum indices, the momentum Score for each stock (in the base index) is based on recent 6-month and 12-month price return, adjusted for volatility. Adjustment for volatility is important. This ensures that more volatile stocks get lower scores. Thus, even in a momentum portfolio, the preference is towards stocks that have had a smoother rise. 

Consider stocks A and B with the following price trajectory.

Stock A: 100, 110, 120, 125, 130, 145, 165, 180, 200

Stock B: 100, 150, 120, 175, 140, 195, 160, 230, 200

While both the stocks have doubled, Stock A will have a higher momentum score since it was less volatile compared to stock B. Hence, momentum investing is not just investing in frothy stocks.

I will skip the remaining details. Those details are important too but you can read the detailed methodology in this document.

Stock weight is capped at lower of 5% or 5 times the weight in the underlying base index.

Things to keep in mind while evaluating Factor Index Products

1. When a factor index fund is launched, it is fair to assume that the underlying factor index would have done quite well in the backtest data. If the factor index has not done well in the past, it wouldn’t find many takers on the supply side (AMCs) or on the demand side (investors).
2. Hence, take such index fund launches and my analysis in this post with a pinch of salt. The past results would be good, otherwise the AMC wouldn’t launch the index fund and I wouldn’t be writing this post today.
3. Past performance (or outperformance) is no guarantee of future performance (outperformance).
4. I am not very comfortable with the very high alpha (excess return) over the base benchmark index. For instance, when I see Nifty Midcap 150 Momentum 50 index has delivered an alpha (excess return) of 7% over Nifty Midcap 150 index over the past 15 years (ofcourse in backtests), I get a bit sceptical.
5. If an investment strategy has done well in backtests and continues to go well going forward, you can expect investors to pile in a lot of money into that strategy. As the funds flow in, the alpha should shrink and may even vanish. Hence, if you want wish to invest in a factor index product based on past performace and conviction, feel free to do that but you must rationalize your expectatations about excess returns. Expecting an alpha of 7-10% p.a. over the benchmark going forward is asking for too much.
6. There is no guarantee that such alpha will sustain in the future. It is possible that the factor strategy may underperform going forward. Again, no certainty about anything. However, you must allow this possbility while deciding the bet size.
7. I wrote a post recently where I compared the performance of various factor indices since the launch against their respective benchmark universe. A factor index fund which did expectionally well in the backtests underperformed massively after the launch of the index.
8. No investment strategy, no matter how good, will do well all the time. It will go through periods of underperformance. It is perfectly normal. In fact, such periods of underperformance may be the source of alpha of any investment strategy over the long term. For instance, if equity markets did better than bank fixed deposits all the time, then everyone would invest in stocks and no one would invest in bank fixed deposits. Gradually, the stocks prices would be bid high enough that alpha vanishes.
9. When you invest in any active fund or a factor index fund, you should have the conviction in the fund manager or the investment strategy. Or else you will enter/exit at wrong times. Remember, investment returns can be different from investor returns.
10. You don’t invest in the index. You invest in an index fund or an ETF that needs to buy and sell stocks. As you move broaden the universe of stocks, you also have to appreciate that smaller stocks may not have very high liquidity. While the index providers try to take care of such issues (by preventing very heavy allocation to smaller stocks), we can’t completely ignore this factor. Discussed this aspect in my post on equal weight indices.

I will present the performance of various momentum indices and leave everything to your judgement.

I compare the monthly data (and not daily data) of Price index. From April 1, 2005 to August 31, 2024.

Nifty Momentum Indices: Performance Summary

Nifty Momentum Indices: Calender Year Returns

Momentum Indices: Rolling Returns

Momentum indices have done quite well on the rolling returns front too. This is not surprising given the wide outperformance in the CAGR over the long term.

Momentum Indices: Volatility and Maximum Drawdown

Along expected lines. You would expect momentum indices to be more volatile and show higher drawdowns than Nifty 50.

Momentum Indices: Performance during various market phases

I compared the performance of various momentum indices over different market phases. During various phases of Nifty returns.

Here too, the performance of momentum indices (remember most of this data is back-fitted) is quite impressive.  Except for minor underperformance when Nifty has returned less than 10%, the momentum indices have done better across all other market phases.

Which Momentum index should you invest in?

Before you get there, you must first decide whether you must invest in any momentum index. Past performance looks great but there is no guarantee that this performance will sustain. Any strategy goes through periods of underperformance or outperformance. You must have conviction to stick with the strategy during poor phases.

Do you believe in momentum investing?

If you don’t, then you must not invest in momentum index funds.

If you do, then you must decide how much to allocate to momentum strategy. Do not get swayed by the past performance shown in this post and put all your eggs in one basket. Construct your portfolio wisely.

Once you have decided the allocation, you must pick a momentum index fund or ETF. You have 3 momentum indices and multiple funds tracking these indices. Which index to choose? I leave that decision to your investment acumen and judgement.

Personally, before selecting an index to invest (from a set of similar funds/strategies), I would prefer to see how these indices performed during adverse market phases. Would prefer the one which keeps me a little less worried during bad market phases. Helps me in maintaining investment discipline and that’s also the key to investment success.

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Disclaimer: Registration granted by SEBI, membership of BASL, and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors. Investment in securities market is subject to market risks. Read all the related documents carefully before investing.

This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.