How Momentum-Based Index Funds Select Their Stocks?

Every investor likes to have the winning stocks in their portfolio. But finding one such stock requires deep analysis and market understanding. This is where the momentum-based index funds come in. By selecting the movers in the market, momentum-based funds try to keep your portfolio ahead of the curve.

But how do they actually pick these stocks? Let us understand the simple yet powerful process behind them.

What are Momentum-Based Index Funds?

Momentum-based index funds mainly invest in those stocks which performed well recently. The strategy that these index funds follow is based on aiming for high price momentum. The key features of the same are:

• Invest in stocks with recent good performance.
• Check for price movement in the past 6 to 12 months.
• Make changes based on volatility.
• Pick the stable performers more.
• Rank the stocks for better selection criteria.
• Use the momentum scores as the ranking baseline.
• Rebalance annually or semi-annually to keep the growth pace.
• Go ahead with proper and planned diversification.
• Try to gain from short and medium-term market trends for higher returns.

Nifty 500 Momentum 50 Index Fund is a great example of one such fund. It selects the top 50 momentum stocks from the Nifty 500 index funds.

How Momentum-Based Index Funds Select Their Stocks

Momentum-based index funds mainly invest in stocks with consistent performance recently. They invest with the simple expectation that this strong performance will continue. Now, to ensure this, a proper strategic approach to selection is adopted. This includes:

1. Defining the Universe

The fund starts with a broad universe of stocks, usually from a large market index. Only stocks that meet certain liquidity and trading criteria are considered to ensure easy buying and selling.

2. Calculating Momentum Scores

Each eligible stock is given a momentum score based on its price returns over a specific period, usually the past 6 to 12 months. This score is often adjusted for volatility to favour stable performers over erratic stocks.

3. Ranking and Selection

All stocks are ranked according to their momentum scores. The top-ranked stocks are selected for inclusion in the fund portfolio.

4. Weighting the Stocks

Weights are assigned to each selected stock based on a set method, often combining momentum scores and market capitalization. Caps are applied to prevent any single stock from having too much weight.

5. Periodic Rebalancing

The fund is rebalanced at regular intervals, such as semi-annually. During rebalancing, scores are recalculated, stocks are re-ranked, and the portfolio is updated to include the current top momentum stocks.

6. Diversification and Risk Controls

Sector and stock caps are used to avoid concentration risk. Additional filters may exclude stocks with low liquidity or poor governance factors to maintain portfolio quality.

Example: Nifty 500 Momentum 50 Index Funds

This fund starts by selecting the top 50 stocks. These are the ones with the highest momentum scores from the Nifty 500 universe. It calculates momentum based on 6 and 12-month returns.

Then it adjusts for volatility and ranks the stocks. These stocks are then ranked based on a proper mix of momentum score and free-float market cap. The index is rebalanced twice a year to keep the portfolio updated with current top performers.

Conclusion

Momentum-based index funds are designed to pick the winners. These are the stocks that offer great returns and have proved to be stable during the recent period. For investors, this means an opportunity to benefit from market trends without actively tracking stocks themselves.

However, these funds can underperform when market trends reverse or become unstable. It is important for investors to know that while momentum funds can deliver higher returns in rising markets, they also carry higher risks. Always match them with your goals and risk tolerance before investing.