2.6.3 Momentum Factor

Why trends have historically tended to persist

Momentum as a factor is built on the observed tendency for stocks that have risen strongly over the past six to twelve months to continue outperforming, on average, over the following few months, and for stocks that have fallen sharply to continue underperforming. This pattern has shown up across many markets and long historical periods, even though the underlying behavioural or structural reasons behind it remain debated among researchers.

The momentum factor buys stocks that have risen the most over the recent past (typically 6-12 months) and avoids or shorts those that have fallen the most. The empirical observation, documented across virtually every stock market and time period studied, is that past winners tend to continue winning over the near term and past losers tend to continue losing. The effect is one of the most robust findings in empirical finance.

The explanation is partly behavioural: investors underreact to positive information, causing good news to be absorbed into prices gradually rather than instantly. A company that beats earnings expectations by a large margin sees its stock rise, but often not enough to fully reflect the improved outlook. The subsequent continuation of the rise, as more investors recognise the improvement, creates the momentum return. Similarly, negative developments are absorbed slowly, with losers continuing to drift down as the bad news is gradually digested.

Why momentum can reverse sharply

Momentum strategies are particularly prone to sudden, sharp reversals, sometimes called momentum crashes, especially around major market turning points when previously strong trends abruptly break down. This is one of the more distinct risks of a momentum-based approach compared to some other factors.

Momentum's primary risk is the sharp reversal. When market conditions change abruptly (a regime shift from risk-on to risk-off, or a sudden rotation from growth to value), momentum portfolios can lose heavily because they are fully invested in the recently winning theme that is now suddenly out of favour. The March 2020 crash is a vivid example: stocks that had been leading the market collapsed along with everything else, and the recovery initially favoured beaten-down stocks rather than prior winners, causing momentum strategies to suffer a double hit.

In India, momentum indices like the Nifty200 Momentum 30 have delivered strong absolute and risk-adjusted returns over the available history (roughly 2005 onward). However, the index is reconstituted semi-annually, and the turnover is inherently high because the portfolio changes as momentum shifts to different stocks. This high turnover generates transaction costs and, for investors holding outside a fund wrapper, potential short-term capital gains tax events.

How momentum is typically used

Momentum is often combined with other factors, such as quality, in an attempt to filter out some of the weaker, more crash-prone momentum signals while retaining the core trend-following benefit. As with any single factor, a dedicated momentum allocation is generally best sized as a smaller, deliberate portion of a broader, diversified portfolio rather than a dominant strategy on its own.