Momentum investing is a popular investment strategy that seeks to capitalize on the tendency of financial assets to continue their recent performance trends. At its core, momentum investing is grounded in the belief that securities that have performed well in the past are more likely to perform well shortly, while those that have performed poorly will continue to do so.
Before delving into momentum investing's intricacies, it is crucial to mitigate survivorship bias. The Nifty 500 universe we examine consists of stocks present in the index as of 2023, omitting companies that were part of the index but delisted. To rectify this bias, we construct our own Equal-Weighted ETF, serving as a benchmark for evaluating momentum investing's performance.
Our analysis is conducted using Nifty 500 stocks and employs two momentum investing approaches:
This method selects the top 'n' stocks based on absolute returns and rebalances the portfolio at fixed intervals. Over one year, with monthly rebalancing, we observe impressive results, including high total returns, a commendable Compound Annual Growth Rate (CAGR), and outperformance of the market. However, this approach leads to increased portfolio volatility.
The second approach introduces an added layer of stock selection, considering not only returns but also volatility-adjusted returns (returns divided by annualized volatility). This method yields outstanding results, featuring higher total returns, a superior CAGR, and reduced drawdowns compared to the first approach and the market index. This approach demonstrates the significance of incorporating volatility into momentum-based strategies.
We explore how the number of stocks in the portfolio affects CAGR and standard deviation. Our analysis indicates that diversification yields diminishing returns, plateauing at approximately 40 stocks. Remarkably, portfolios with volatility-adjusted returns exhibit higher standard deviations, but the higher risk is well compensated by higher returns.
In conclusion, momentum investing, as examined within the Nifty 500 universe, presents intriguing possibilities. Leveraging momentum can potentially lead to outperformance of traditional market indices. However, it is essential to consider nuances such as survivorship bias, the integration of volatility-adjusted returns, and the balance between stock selection, diversification, and risk management. These factors play a pivotal role in the success of momentum investing strategies.