Momentum investing: short-term dip, long-term gain

Momentum factor investing is a strategy that capitalizes on the trend of stocks that have performed well recently and tend to follow their trends in the near future. This ‘buy high, sell higher’ approach is based on identifying and following persistent upward price trends. The strategy offers the potential for high returns through capitalizing on behavioral biases and market inefficiencies, but is inherently exposed to risks such as sudden reversals and increased volatility, especially during uncertain or rapidly changing market conditions.Currently, momentum investing is facing significant headwinds. The market is characterized by increased volatility, frequent sector rotations and macroeconomic uncertainties that can disrupt clear and sustainable trends. These conditions often create false signals, which can be challenging for momentum strategies that rely on consistent trend persistence. Additionally, momentum portfolios often contain high-beta and richly valued stocks, which can suffer greater losses if market sentiment changes abruptly.

Over the past 1 year, the Nifty 500 Momentum 50 Index has underperformed the Nifty 500 Index by about 15%. However, historical data shows that such phases of underperformance are cyclical and temporary, often followed by outperformance once market leadership stabilizes. This cyclical nature underlines the importance of discipline and patience among investors.

Underperformance fades with time

The rolling returns analysis shows that while the momentum index may lag the Nifty 500 over short periods of time, such phases are neither frequent nor persistent. Over a one-year period, underperformance occurred in approximately 28% of cases, with an average deficit of approximately -10% in those cases. The frequency of underperformance fell sharply to 16% over a three-year period and was very low (3%) over a five-year period. Moreover, momentum has never underperformed the Nifty 500 index over a seven-year period. This pattern shows that both the probability and severity of underperformance steadily decrease over time, supporting the long-term resilience of momentum investing.

Short-term weakness has historically led to long-term strength

The 1-year excess rolling return chart highlights that short-term momentum underperformance is not an exception, but a recurring part of the returns cycle. The strategy periodically moves into negative territory when trends reverse or previous market leaders correct sharply. While these underperformances may seem sharp, they have historically been temporary and represent the natural reset phase of the momentum cycle, where old trends fade and new trends begin to form.

What makes these short-term dips important is what usually follows. Looking at the forward return data, periods of recent underperformance have been followed by stronger future excess returns. This relationship shows that the weakest phases of momentum have often been the periods that reset trends and provided favorable entry points.When underperformance is greatest (less than –20%), excess returns average 7.6% over one year, 8.9% over three years, and 12.4% over five years – results that are remarkably strong within the sample. Even bands with moderate underperformance continue to show healthy excess returns across all time horizons.

Importantly, the current underperformance of approximately -15% is in the ‘-20% to -10%’ range – a zone that has historically delivered excess returns of 9.7% (1 year), 6.7% (3 years) and 8.7% (5 years). This bucket is also relatively rare, occurring in only 5% of all observations, making such phases unusual but historically worthwhile.

At the same time, while momentum has only advanced slightly (0% to +10%), future returns have remained strong due to the continuation of the trend. But when the outperformance is extremely high (more than 20%), the excess return drops sharply. Over a year it becomes marginally negative and over a longer period only slightly positive.

Overall, the data suggests a simple, repeatable pattern: the more momentum has struggled recently, the more likely it is to deliver excessive long-term returns – and the more it has risen recently, the weaker its future performance tends to be. And the current underperformance is right in the range that has historically led to meaningful long-term gains.

Conclusion

Momentum investing naturally goes through phases of sharp reversals and trend resets, and the current underperformance is consistent with the historical cycle. The rolling returns and forward returns data show that these weak periods are generally temporary and have often led to strong, multi-year outperformance.

Taken together, the evidence points to a simple but remarkable insight: short-term momentum setbacks have paved the way for long-term outperformance. For investors, this underlines the importance of staying disciplined through cycles and recognizing that temporary weakness is not a signal to get out of the market, but has historically been an opportunity to participate in the next phase of trend formation.

(The author is Head of Passive Business at Motilal Oswal Asset Management Company)