Momentum investing is a popular strategy where investors focus on stocks that have shown positive trends in terms of price movement, believing that these stocks will continue to perform well in the future. While many investors are aware of the basic principles of momentum investing, there are some hidden advantages to this strategy that are often overlooked.
One underappreciated aspect of momentum investing is the ability to select strong stocks from a universe that includes both strong and weak stocks. Typically, investors aim to pick the stronger stocks from this universe, but the issue arises when the universe itself is slow to change its constituents. For instance, let’s consider the Nifty or Nifty Next 50 index, which is commonly tracked by momentum investors. These indices often take a long time to remove underperforming stocks from their constituents.
This delay can be problematic for investors holding the Nifty or similar indices, either through exchange-traded funds (ETFs) or index funds. Even if you consciously avoid weak stocks, a percentage of your portfolio will still be allocated to these underperforming stocks until the Nifty rebalance committee removes them at their semi-annual meetings. This means that you are forced to hold these weak stocks as part of your exposure to the index and all its constituents.
This is where momentum investing strategies excel. They not only seek strength within the chosen universe but also have the advantage of removing underperforming stocks much earlier than the index does. Let’s look at a few examples to illustrate this point.
India Bull Housing Finance, Yes Bank, and Zee Entertainment are stocks that took a significant amount of time to be removed from the Nifty index. However, the momentum strategy “Mi India Top 10,” which tracks Nifty 50 stocks, removed India Bull Housing Finance much earlier in 2018, a whole 17 months before it was eliminated from the index in September 2019.
Similarly, the index removed Yes Bank after its collapse from Rs400 to Rs20, while the momentum strategy had already exited the stock and never looked back.
The strategy also removed Zee Entertainment at a much higher price compared to when the index eventually got rid of it.
These examples demonstrate the advantage of momentum investing in terms of timely exits from declining stocks. While the index might take months or even years to remove such stocks, momentum strategies can quickly identify weaknesses and eliminate them from the portfolio. By doing so, investors avoid holding onto underperforming stocks while simultaneously opening up opportunities for new stocks with stronger potential.
This advantage is not limited to just a few stocks. The momentum strategy consistently outperforms the index by eliminating weak stocks ahead of the index rebalancing process. While the index lags, momentum strategies track strength in the index and adjust their constituents accordingly. As a result, investors following these strategies are well-positioned to benefit from new stock additions that display even greater strength.
It’s important to note that these subtle advantages of momentum investing may not be immediately apparent. However, the inherent safeguards built into this strategy ensure that it performs better than simply holding onto an index. By actively removing underperforming stocks and staying ahead of the index in terms of stock selection, momentum investors can optimize their portfolios and increase their chances of achieving favorable returns.
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