How to manage risks in momentum trading? Consider a multi-factor approach for sustainable returns

Following the trend and keeping pace with it is the basic nature of being human. Doing the same with the stock market is also a fascinating activity. When we follow the market trend, the strategy is known as momentum investing. This is a strategy where you invest in a rising stock hoping that it will continue to rise.

Financial advisors have also surfed the trend by offering momentum portfolios. While this strategy may seem tempting at first glance, one must also consider the risks associated with dynamic investing and how to manage those risks.

This article will guide you on the risks of momentum investing, how you can manage these risks with a multi-factor sustainable approach and analyzing data from various momentum funds.

What is momentum investing?
Dynamic investing involves buying stocks that have shown upward price movements over the past six to twelve months. The basic phenomenon behind momentum investing is that the trend will continue whether it is bullish or bearish.

Dynamic Investing Risks
One of the biggest risks associated with momentum is that of high volatility.

Volatility refers to the rate at which the price changes. You put all your eggs in one basket every time you invest in a focused strategy. In momentum investing, you risk your money on the success of stocks by considering only one factor, namely momentum.

A famous quote from Warren Buffet, “It’s not until the tide goes out that you find out who’s been swimming naked.” This quote is perfect for dynamic investing.

For example, you buy a dynamic fund that invests in companies showing upward price movements over the last 6 months. Here you expect the uptrend to continue for longer.

After the investment, if the price continues to rise, you are likely to enjoy higher returns. However, if stock prices are stable, this fund will perform poorly.

In the worst case scenario, if stock prices fall, you are likely to suffer huge losses due to your reliance on momentum.

In a downtrend period, investors are skeptical of the stocks they have invested in, only considering price movements. If equities underperform for longer, contrary to expectations, investors will wash their hands of a tidy sum of money.

How to deal with the risks?
To deal with the risks associated with dynamic investing, you can diversify your holdings.

A) One way to diversify your holdings is to select a fund that takes into account several factors.

This type of multifactor fund will choose stocks based on factors such as momentum, low volatility, quality, value,

. The performance of a multifactor fund is not based solely on momentum, thus ensuring sustainable returns over the long term.

Mainly, there are two ways to build a multifactor strategy. One is to assign equal weight to all factors considered.

B) The second way is to identify the current market regime and assign more weight to factors that are likely to work in the current market regime.

Our proprietary AI/ML-based algorithms come into play taking into account key macroeconomic factors such as the exchange rate, inflation, interest rates, and commodity prices, and more to identify the current market conditions and focus on factors that are important given the current market conditions.

The shares of the funds are included after analyzing all these essential factors.

Advantages of the multifactor approach
Among more than thousands of organized portfolios listed on the different platforms, we analyzed 30 funds classified as dynamic funds.

If you look at the performance of the four most popular dynamic portfolios, they generated returns in the range of -5.7% to a maximum of 4.47%.

Let’s look at the maximum, minimum and average returns of the 30 momentum portfolios.

Maximum return – 11.3%

Minimum return – 21.7%

Average return – 1.72%

In addition, 16 of the 30 dynamic portfolios gave negative returns. And 4 momentum portfolios returned below the 10% mark. There were only two dynamic portfolios that gave returns above 10%.

The 3 most popular dynamic portfolios have given an average return of 4.7% over the last 6 months. By comparison, the top 3 multifactor portfolios have averaged returns of 12% over the past 6 months. These numbers illustrate the lasting advantage created by multifactor portfolios.

Funds based on a single factor like momentum can outperform when the factor works. However, it is likely to end up underperforming in the long run.

The multi-factor approach helps you diversify your holdings and ultimately produce sustainable returns over the long term.

The performance of momentum funds depends on a single factor. The main disadvantage of dynamic funds is the lack of diversification and the volatility of returns.

If you want to generate sustainable returns over a longer period, the best idea is to consider multifactor funds.

(Disclaimer: The recommendations, suggestions, views and opinions given by the experts belong to them. These do not represent the views of Economic Times)

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