What it means
Most momentum funds start with a large universe of shares and rank them by past return, commonly over the previous six to twelve months. The fund holds the top-ranked group and replaces holdings as their ranking drops, so the portfolio is constantly refreshed with whatever is currently strong.
Because the selection rule is mechanical, many momentum funds follow an index and are offered as exchange-traded funds (ETFs, funds that trade on a stock exchange like a share). Others are actively managed and combine a momentum screen with a manager's judgement about quality, valuation or risk.
The attraction is that momentum has historically been one of the better-documented sources of extra return, although no one can promise that it will continue. The strategy tends to do well when trends are persistent and market leadership is clear, and it can struggle when markets turn suddenly.
Costs matter more than with a typical index fund. Holdings change frequently, so the fund pays more in trading costs, and in taxable accounts frequent selling can create realised gains that reduce an investor's after-tax return.
Momentum funds also tend to have concentrated exposure to whatever has recently led the market, such as a particular sector or style. After a long rally, that can mean heavy exposure to expensive shares, so investors should check the fund's top sectors and holdings and not rely on the label.
Many investors use momentum funds as one component alongside broad market, value and bond funds, rather than as the whole portfolio. That approach spreads the risk that any single style falls out of favour for several years.
In practice
Real-world examples.
Example
A retirement saver adds a momentum ETF alongside her broad index fund. She puts 15% of her equity money in it and reviews the allocation once a year. She understands that the fund may lag the market in some years and accepts that as the price of diversification.
Example
An advisory firm offers clients a rules-based momentum portfolio that holds the 50 strongest shares from a universe of 500. The firm rebalances quarterly and publishes the rules so clients can see exactly why each share was bought or sold.
Example
A pension fund's investment committee notices that its manager's momentum fund has become heavily weighted in one sector. The committee asks for a risk report and sets a sector limit to avoid being surprised by a sharp reversal. It also requires the manager to explain how the fund would behave in a market fall.
Formula
Calculation
Net return = Gross return - Expense ratio - (Annual turnover x Round-trip trading cost)
A momentum fund earns a gross return of 14.0% before costs. Its expense ratio is 0.75%, its annual turnover is 120% of the portfolio, and each full round trip (selling one holding and buying another) costs 0.40% in spreads and commissions. The trading cost drag is 1.20 x 0.40% = 0.48%. Net return is 14.0% - 0.75% - 0.48% = 12.77%. On a $100,000 investment that is $12,770 for the year, compared with $14,000 before costs.Case study
Seen in the real world.
Ridgeway Asset Management is an illustrative, fictional firm that launched a momentum fund with $20,000,000 in assets. The rule was to hold the top 40 of 400 shares ranked by 12-month return, excluding the latest month, and to rebalance every quarter.
In its first two years the fund beat its benchmark by around 3 percentage points a year. It then faced a sudden rotation when leaders in the technology sector fell and unloved shares rallied, and the fund lagged the market by 9 percentage points in six months.
Some investors left in frustration. Ridgeway's fictional managers pointed out that the fund had behaved exactly as designed and that the drawdown was part of the risk, then introduced a rule to cap any sector at 25% of the portfolio, which reduced the severity of later reversals.
Watch out
Common mistakes.
- Treating a momentum fund as a low-risk fund, when it can fall sharply during market reversals and may fall further than the overall market.
- Judging the fund only by its past returns without checking turnover, costs and sector concentration.
- Buying after a long rally and expecting the same results, since much of the recent performance may already have occurred.
Questions
People also ask.
How is a momentum fund different from an index fund?
A traditional index fund holds shares in proportion to their size, while a momentum fund picks those with the strongest recent performance. It trades more often and has a more concentrated profile.
When do momentum funds do badly?
They tend to struggle when markets change direction quickly, such as sharp rebounds after a crash. Leaders can become laggards almost overnight.
Are momentum funds suitable for everyone?
Not necessarily, since they involve higher turnover and style risk. Investors should consider their time horizon, tax position and the role the fund would play in the portfolio, and ideally speak to a qualified adviser.
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