The Momentum Factor

Momentum is the most counterintuitive factor in systematic investing. It says: buy stocks that have gone up a lot recently, because they will keep going up. Sell stocks that have gone down a lot, because they will keep going down.

Everything about this feels wrong to value-trained investors. You're buying high and expecting to sell higher. You're chasing performance. You're doing exactly what every investment textbook tells you not to do.

And yet, momentum is one of the most documented return anomalies in financial history. It has been found in every major equity market studied | US, Europe, Japan, and India. It has been replicating since Jegadeesh and Titman first documented it in 1993. It generates some of the highest factor premia of any single factor. And it is the backbone of RupeeCase's flagship strategy.

This module goes deep on why it works, how to measure it correctly, and | critically | where it fails catastrophically.

The evidence: what Jegadeesh and Titman found

In 1993, Narasimhan Jegadeesh and Sheridan Titman published "Returns to Buying Winners and Selling Losers" in the Journal of Finance. Their finding: stocks that performed well over the past 3 to 12 months continued to outperform over the next 3 to 12 months, and vice versa. This wasn't a small effect. The top-decile momentum portfolio outperformed the bottom decile by roughly 1% per month over the next 6 months.

This was replicated globally. Rouwenhorst (1998) found it in 12 European countries. Fama and French included momentum in their factor models. Asness, Moskowitz, and Pedersen (2013) found it in "Value and Momentum Everywhere" | equities, bonds, currencies, and commodities across 59 assets and 40 years.

Why momentum exists: three explanations

1. Underreaction to news

Markets don't immediately fully price new information. When Infosys announces strong quarterly results, the stock rises | but not to its new fair value instantly. Investors anchor to the old price, adjust slowly, and the stock continues rising over subsequent weeks and months as the information fully diffuses. Momentum captures this gradual repricing process.

2. Investor herding

As a stock rises, it attracts media coverage, analyst upgrades, and retail investor attention. This creates a self-reinforcing cycle: price goes up → more attention → more buying → price goes up more. The cycle doesn't reverse until sentiment breaks | which tends to happen suddenly, which is why momentum crashes are sharp.

3. Trend-following institutional behaviour

Many institutional investors, particularly CTAs (commodity trading advisors) and systematic funds, explicitly follow trends. Their buying reinforces existing trends. Since institutional assets have grown substantially, trend-following capital may itself be sustaining some of the momentum effect.

How to measure momentum correctly

This is where most retail momentum implementations go wrong. The standard signal in academic literature is:

The skip-1-month rule is critical and widely misunderstood. The last month's return tends to reverse | not continue. This is the short-term reversal effect (Jegadeesh, 1990). If you include the last month, you're partially betting on reversal, which works against momentum. Excluding it sharpens the signal significantly.

Momentum in Indian markets | the specific evidence

NSE publishes official factor index data for the Nifty Alpha 50 and Nifty Momentum 30 | both track momentum strategies on Indian large and mid-cap stocks. The evidence is consistent with global findings: momentum has generated significant alpha over the Nifty 500 benchmark over most measured periods.

A few India-specific observations from RupeeCase's own backtesting:

• Momentum is stronger in the mid-cap and small-cap segment | Nifty 500 universe shows stronger momentum premia than Nifty 50 alone, because smaller stocks are less efficiently priced
• Sector concentration is a known issue | in strong sectoral bull markets (2021 PSU rally, 2023 defence stocks), momentum portfolios can become heavily concentrated in one or two sectors. Risk management requires monitoring this
• Weekly rebalancing outperforms monthly in Indian markets on a gross basis, but the cost advantage disappears once transaction costs are applied for most retail portfolio sizes

The momentum crash | when it fails

Momentum is the factor most prone to catastrophic failure. In sharp market reversals | when markets turn from downtrend to uptrend very quickly | momentum portfolios hold the recent losers (which are now the new winners) at zero weight, and are fully invested in the recent winners (which are now crashing hardest).

The three conditions that produce a momentum crash:

• High market volatility | when VIX spikes, recent winners tend to be the most crowded and the most vulnerable to forced selling
• Sharp market reversal | momentum requires trend persistence. A sharp reversal kills the trend before it can be captured
• High dispersion of prior returns | when the spread between winners and losers is very large, the crash when it comes is correspondingly large

This is why combining momentum with other factors | particularly Low Volatility and Quality | is so important. These factors tend to perform well precisely when momentum crashes. The correlation between them is low or negative, which is the mathematical foundation of multi-factor diversification.

Momentum variants worth knowing

Glossary