Market darlings took a hit as momentum funds faced sharp declines amid volatility
Momentum investing, a strategy that capitalizes on the continuance of existing market trends, has historically yielded substantial returns. However, recent market dynamics have led to significant setbacks for momentum funds, prompting investors and analysts to scrutinize the causes and implications of this downturn.
Understanding Momentum Investing
Momentum investing involves purchasing securities that have exhibited strong performance over a specific period and selling those that have underperformed. This approach operates on the premise that assets demonstrating upward price trends will continue to appreciate, while those on a downward trajectory will persist in their decline. Despite its potential for high returns, momentum investing is susceptible to abrupt reversals, known as momentum crashes, which can result in substantial losses.
Recent Performance of Momentum Funds
In recent months, momentum-based funds have experienced notable declines. For instance, in October 2024, as the broader equity market turned negative, momentum funds faced sharper downturns. The Nifty 200 Total Return Index (TRI) declined by 9.9% since September 26, while momentum-based indices plummeted up to 12.1%. This disparity underscores the heightened sensitivity of momentum funds to market corrections.
Factors Contributing to the Momentum Funds Crash
Several interrelated factors have contributed to the recent underperformance of momentum funds:
Market Corrections and Volatility
Momentum strategies are particularly vulnerable during market corrections. When the overall market declines after a prolonged uptrend, stocks that had been performing well can drop sharply, causing significant losses for momentum investors. These crashes are frequently seen during market corrections, leading to a significant drop in momentum stocks.
Economic Shifts and Policy Changes
Unexpected economic data or changes in economic conditions can cause a sudden reversal in market trends, adversely affecting momentum strategies. Additionally, investor behavior, such as herding, where many investors follow the same trend, can lead to overcrowded trades. When these trades unwind, it can cause sharp price declines, exacerbating the momentum crash.
Liquidity Constraints
During periods of market stress, liquidity can diminish, leading to larger price swings for momentum stocks. This lack of liquidity means it becomes harder to sell off assets quickly without significantly impacting their prices, which can lead to steep declines in the value of these stocks during a crash.
Case Studies: Hedge Funds Affected
Prominent hedge funds have not been immune to the challenges facing momentum strategies. In early March 2025, renowned firms such as Millennium Management and Point72 reported losses of approximately 1.4%, while Schonfeld faced a 1.2% downturn. These declines were attributed to market volatility influenced by policy uncertainties under President Donald Trump’s administration, leading to the unraveling of momentum-linked trades.
Predictability and Management of Momentum Crashes
Research indicates that momentum crashes are partly forecastable. They tend to occur in “panic” states—following market declines and when market volatility is high—and are contemporaneous with market rebounds. Understanding these patterns can aid investors in anticipating potential downturns in momentum strategies.
Strategies to Mitigate Risks
To reduce the impact of momentum crashes, investors can consider the following approaches:
Diversification: Incorporating a mix of investment strategies can balance the risks associated with momentum investing.
Risk Management Protocols: Implementing stop-loss orders and regular portfolio rebalancing can help manage potential downturns.
Awareness of Market Conditions: Staying informed about economic indicators and market sentiment can provide early warnings of potential reversals.
The recent downturn in momentum funds highlights the inherent risks associated with momentum investing. While this strategy can offer substantial returns during stable or rising markets, it is particularly susceptible to sharp reversals during periods of market correction and heightened volatility. Investors employing momentum strategies should remain vigilant, adopt robust risk management practices, and stay attuned to broader economic and policy developments to navigate the complexities of the financial markets effectively.
