What are Momentum-Based Mutual Funds? Meaning, Working, and More

Momentum mutual funds are equity schemes that may invest in stocks showing sustained strength in their market prices. Generally, their portfolios are built around the expectation that stocks with strong market trends may retain that strength for a period.
Depending on the scheme, stock selection may follow a predetermined model or involve decisions by an active fund manager.

In the markets, there are different types of equity mutual fund schemes based on their investment style. Some follow a particular market capitalisation, while others invest in a specific theme or follow strategies such as value or contrarian investing. 

Among these are the momentum-based mutual funds, which follow a momentum investing strategy by selecting stocks that have shown strong recent price performance. 

Read this article to learn what momentum mutual funds are, how they work, and the difference between passive and active approaches.

Momentum-based mutual funds are a type of “equity” fund primarily investing in stocks or securities that have demonstrated strong recent price performance, say over the past 3 to 12 months.

The core investment principle is based on the “momentum factor”. It assumes that the securities that have been rising in value are likely to continue their upward trend, while those declining may continue to fall.  

Unlike value funds, which seek “undervalued assets”, momentum funds may target existing market trends to generate potentially higher returns. It is worth mentioning that momentum mutual funds are available in both passive and active investment styles.

Most momentum-based mutual funds are “passive” and do not depend on a fund manager's selection of stocks. Instead, they follow a pre-defined benchmark index or set of rules to decide which stocks to include. 

For example,

• A common index used as a benchmark is the Nifty 200 Momentum 30.
• It selects 30 “high-momentum” large and mid-cap stocks from the Nifty 200 universe based on their recent price performance. 
• Now, a momentum mutual fund tracking/ replicating this benchmark index may replicate its stocks and weightages (rather than actively selecting stocks). 

But how are these stocks selected? The passive momentum approach generally uses a “rule-based” process to find stocks. Let’s understand the step-by-step process in detail:

Step I: Measure the Stock's Recent Price Performance

To identify stocks, the index generally looks at returns over one or more predefined periods, such as 6 months and 12 months.

Step II: Calculate Momentum Returns (MR) and Adjust for Volatility

Momentum return refers to the stock’s price return over the period used to measure its momentum. For example, 

• Suppose a stock’s price rises from ₹100 to ₹120 over 12 months.
• Now, its 12-month momentum return 

• Similarly, if its price rises from ₹100 to ₹110 over 6 months, its 6-month momentum return is 

Now, a stock may have a high MR but also experience large price fluctuations. Therefore, several passive momentum investing strategies may also adjust the MR for the stock’s annualised daily volatility over a predefined period, such as the previous 1 or 2 years. 

Usually, the calculations are performed as follows:

These ratios show how much potential MR a stock has generated relative to its price volatility. Usually, a higher ratio indicates stronger momentum in relation to the stock's volatility.

Step III: Convert the ratios into Z-scores

The 6-month and 12-month momentum ratios cannot simply be compared as they are. They are converted into “Z-scores”, which show how far a stock's momentum ratio is from the average of the stocks being assessed.

The basic Z-score formula is:

Where,

• X = The stock's momentum ratio
• μ = Average momentum ratio (MR)
• σ = Standard deviation of the momentum ratios

Generally, a higher Z-score shows that the stock's momentum ratio is higher relative to the other stocks in the group. The 6-month and 12-month Z-scores are then combined to produce one “Normalised Momentum Score” for each stock.

Step IV: Rank and Select the Stocks

After calculating the normalised momentum score for each stock, they are ranked from the highest score to the lowest. The passive momentum investment strategy then selects the stocks that meet its predefined selection rule, such as a fixed number or a minimum momentum-score threshold. 

Step V: Decide the Weight of Each Stock

Lastly, once the stocks are selected, the strategy determines how much of the portfolio should be invested in each stock. The weighting method depends on the rules of the particular momentum index or fund. 

Some strategies may give greater weight to stocks with stronger momentum scores, while others may also consider free-float market capitalisation. 

Additionally, there may also be a maximum weight limit for an individual stock. Such a weighting may potentially prevent a single stock from taking up an excessively large share of the portfolio. 

Note: The exact weighting formula and limits can differ across passive momentum-based mutual funds and the indices they track.

As per general market understanding, active momentum-based mutual funds use recent market performance as an important basis for selecting stocks. Unlike passive momentum mutual funds, which generally follow a predefined index, an active fund manager has the discretion to decide which stocks to buy, hold, or sell. 

The manager may use data about past price movements and other market indicators to identify stocks that show strong potential momentum. Later, the portfolio can be “rebalanced” when the manager believes a stock's momentum has weakened.

For a greater understanding, let’s check out the various factors commonly analysed by fund managers to execute the momentum investment strategy:

So, now you know what momentum-based mutual funds are and their two major types: Passive and Active. If we were to revise, passive momentum mutual funds follow a “predefined + rule-based” process to select stocks. The process may include the following steps: 

• Assess recent price returns
• Adjust them for volatility
• Calculate normalised momentum scores
• Rank stocks, and
• Lastly, assign portfolio weights 

On the other hand, active momentum mutual funds give the fund manager greater discretion to identify stocks with strong price trends using quantitative analysis, technical indicators, and historical price data. The portfolio may change as the fund manager's assessment of momentum changes. 

However, momentum investing does not guarantee that a past trend will continue. Selected stocks can lose value when market conditions or price trends change.

For more information, you can visit www.tatamutualfund.com/deshkarenivesh. The Investor Service Centre of Tata Asset Management Pvt. Ltd. is located at Mulla House, Ground Floor, 51, M.G. Road, Near Flora Fountain, Mumbai – 400 001, Maharashtra. The office hours are Monday to Friday, 9:00 AM to 5:30 PM. For assistance, you can also call (022) 6282 7777 from Monday to Saturday, 9:00 AM to 5:30 PM, or email service@tataamc.com

1. What are momentum-based mutual funds, and how do they work?

As per general market understanding, momentum mutual funds may invest in stocks that have shown strong price performance over a recent period. 

The momentum investing strategy is based on the idea that stocks with momentum may continue their uptrend or downtrend for some time. Depending on the investment style, stocks may be selected through predefined rules or by an active fund manager using price trends, quantitative analysis, and other market indicators.

2. What is a passive momentum mutual fund, and how does it differ from an actively managed fund?

A passive momentum mutual fund follows a predefined index or set of rules to select and weight stocks. The process may assess price returns, volatility, momentum scores, and other factors without relying on individual fund manager decisions. 

An active momentum fund gives the fund manager discretion to select, hold, or sell stocks based on their discretionary assessment of momentum.

3. What are the risks of investing in a momentum-based mutual fund?

Momentum strategies carry equity-market risk and do not guarantee that a stock's recent price trend will continue. A trend can reverse, causing selected stocks to lose value.

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