Five reasons: Why the Capitalmind Momentum portfolio can be a long-term wealth builder

Momentum is a rule-based investing system that buys and sells based upon recent price action. Momentum investors buy outperforming securities and avoid – or sell short – underperforming ones.

Momentum embraces the concept f buying high and selling higher. Yes, it certainly sounds counterintuitive to the conventional wisdom of buying low and selling high. But you know what, in stock markets – there are more than one ways to skin a cat.

With a live track record of over four and a half years, it is the longest-running momentum smallcase on the platform and continues to be one of the most trusted investment strategies available.

As practitioners of Momentum investing, we believe momentum investing provides a sustainable framework to generate alpha on a long term basis.

The reasons for this belief?

Reason #1 – The Momentum factor has been globally proven

Momentum as a factor enabling excess returns goes back over a century. It is one of the most researched quantitative factors by academics and practitioners.

While Indian investors discovered Momentum in the recent market euphoria, it has been a robust and popular investing theme since centuries.

Several papers have since been published on the topic. An exhaustive validation of momentum as an investment strategy was undertaken by the quantitative hedge fund AQR, called “Fact, Fiction and Momentum Investing”, which examined the prevalence of momentum across asset classes and countries going back two centuries.

The existence of momentum is a well-established empirical fact. The return premium is evident in 212 years of U.S. equity data (from 1801 to 2012) — as well as U.K. equity data dating back to the Victorian age in over 20 years of out-of-sample evidence from its original discovery, in 40 other countries and in more than a dozen other asset classes. Some of this evidence predates academic research in financial economics, suggesting that the momentum premium has been a part of markets for as long as there have been markets.

Reason #2 – Momentum investing works in India

At Capitalmind, we started examining the prevalence of the momentum factor in Indian markets way back in 2017. We published our research on what we found in the paper titled “Does momentum investing work in Indian equities?“.

In a nutshell, over a 15-year period, even a basic strategy we call “naive momentum” that buys stocks with strong price momentum outperforms the benchmark by a decent margin even after considering costs and taxes.

Reason #3 – Rigorously backtested implementation

The naive momentum model of buying stocks with relatively higher absolute price returns offers excess returns but has its drawbacks. We set about improving the measurement of the momentum factor by incorporating modifications. Adjusting raw return for price volatility, incorporating absolute and trending traded volume, risk-weighted allocation, and other signals to qualify inclusion candidate stocks are examples of a few modifications we have examined.

Quantitative investing is an ever-evolving field of exploration, so the ability to go back to the drawing board to test various hypotheses and incorporate what works into the model is a key component of how we look at our investment models.

Reason #4 – Paying attention to the downside

Historically equity markets trend up nearly 70% of the time. However, they go through deep corrections of 50% or more every now and then. While no equity investment strategy is immune to corrections, a strategy that can limit its downside to the extent of or slightly better than benchmark has a significant chance of outperforming over the long term.

The presence of inclusion criteria has worked, in real market conditions, to reduce exposure to equities in times of broad market corrections allowing for reduced exposure at the time markets are at their weakest.

Reason #5 – Hard-won real-world track record

In theory, there is no difference between theory and practice. In practice there is. – Yogi Berra

There is a saying that the backtest is never the strategy. Capitalmind Momentum has been live on smallcase since Jan 2019. Through the indifferent first year, the sudden crash in 2020 and the subsequent recovery. Real-world experience of contrasting conditions have served to improve the way it works and more importantly, establish its credibility as a long-term wealth builder.

It is not a silver bullet offering unrealistic visions of daily outperformance, but a tried, tested and disciplined method of investing meant for the long term.

And here are five reasons NOT to invest in Capitalmind Momentum

Reason #1 not to – Momentum investing is high(er) churn. As a rule-based investing approach, it buys the stocks that meet the criteria while selling those that do not. So the average turnover of the portfolio is higher compared to traditional fundamental bottom-up investment strategies.

Reason #2 not to – Have to get used to being wrong. Nearly half of all positions in a momentum investing portfolio exit at losses, which means it is wrong half the time. The potential for excess returns over longer holding periods comes from losing less on the losers and winning big on the winners.

Reason #3 not to – Can sometimes hold “ugly” stocks. Ugly stocks are the opposite of story stocks. Companies that no fund manager likes to talk about because they are unfashionable. Since Momentum investing does not consider the narrative and only the price return, it sometimes holds stocks that do not offer bragging rights.

Reason #4 not to – Momentum will get written off. From time to time, it will seem like momentum has “stopped working”. This is most felt by investors who don’t completely understand the underlying concept before entering. Like for any investment style, there will be times when it is declared as ineffective.
Reason #5 not to – Momentum will underperform. Even our backtests show that on a one-year rolling basis, momentum investing trails the benchmark Nifty 30% of the time. Over longer holding periods, the probability of underperformance drops significantly, but that doesn’t change the fact that for nearly a third of the time returns will trail the index.