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

Momentum factor investing is a strategy that capitalises on the tendency of stocks that have recently performed well and tends to follow their trends in the near future. This "buy high, sell higher" approach relies on identifying and following sustained upward price trends. The strategy offers potential for high returns due to capitalising on behavioural 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 faces significant headwinds. The market has been characterised by increased volatility, frequent sector rotations and macroeconomic uncertainties that can disrupt clear & lasting trends. These conditions often create frequent false signals, which can be challenging for momentum strategies that rely on consistent trend persistence. Moreover, momentum portfolios often include high-beta and richly valued stocks, which can suffer amplified losses when market sentiment shifts abruptly.

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Over the past 1 year, the Nifty 500 Momentum 50 Index has underperformed the Nifty 500 Index by around 15%. However, historical data show that such phases of underperformance are cyclical and temporary, often followed by outperformance once market leadership stabilises. This cyclical nature underscores the importance of investor discipline and patience.

Underperformance Fades with Time

The rolling return analysis shows that while the momentum index can lag the Nifty 500 over short periods, such phases are neither frequent nor persistent. Over 1-year windows, underperformance occurred in about 28% of the time, with an average shortfall of about -10% during those instances. The frequency of underperformance dropped sharply to 16% over 3-year periods and was very low (3%) over 5 years. Furthermore, over any 7-year period, momentum has never underperformed the Nifty 500 index. This pattern shows that both the likelihood and the severity of underperformance steadily fade with time, supporting the long-term resilience of momentum investing.

Short-Term Weakness Has Historically Set Up Long-Term Strength

The 1-year excess rolling return chart highlights that momentum’s short-term underperformance is not an exception but a recurring part of its return cycle. The strategy periodically dips into negative territory when trends reverse or when earlier market leaders correct sharply. Although these underperformances can look 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.

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What makes these short-term dips important is what tends to follow. When we look at the forward returns data, periods of recent underperformance have been followed by stronger future excess returns. This relationship shows that momentum’s weakest phases have often been the periods that reset trends and offered favourable entry points.

When the underperformance is deepest (less than –20%), forward excess returns average 7.6% over 1 year, 8.9% over 3 years and 12.4% over 5 years — results that are notably strong within the sample. Even moderate underperformance bands continue to show healthy forward excess returns across all time horizons.

Importantly, the current underperformance of around -15% sits in the “-20% to -10%” bucket — a zone that historically delivered 9.7% (1-year), 6.7% (3-year), and 8.7% (5-year) forward excess returns. This bucket is also relatively rare, occurring in only 5% of all observations, which makes such phases unusual but historically rewarding.

At the same time, when momentum has been only slightly ahead (0% to +10%), future returns have remained strong due to trend continuation. But when outperformance is extremely high (more than 20%), forward excess returns fall sharply, turning marginally negative over 1 year and only mildly positive over longer horizons.

Overall, the data suggests a simple, repeatable pattern: the more momentum has struggled recently, the higher its chances of delivering long-term excess returns — and the more it has recently surged, the more muted its future performance tends to be. And current underperformance sits in precisely the range that has historically led to meaningful long-term gains.

Conclusion

Momentum investing naturally goes through phases of sharp reversals & trend resets, and the current underperformance is consistent with its historical cycle. The rolling return and forward-return data both show that these weak periods have typically been temporary and have often set up strong multi-year outperformance.

Taken together, the evidence points to a simple but notable insight: momentum’s short-term setbacks have paved the way for its long-term outperformance. For investors, this highlights the importance of staying disciplined through cycles and recognising that temporary weakness is not a signal to exit but has historically been an opportunity to participate in the next phase of trend formation.

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