Momentum Strategy
An investment approach that allocates to the largest companies based on market weight, creating self-reinforcing price increases
Momentum Strategy
Definition
A momentum strategy is an investment approach that allocates capital based on recent price performance or market capitalization weight — the assumption being that rising stocks will continue to rise. Terry Smith argues that index funds are implicitly a momentum strategy: money flows to the largest companies, boosting their prices further, which increases their weight, attracting more flows.
Passive Investing as Momentum in Disguise
Smith's key insight from the 2025 Fundsmith AGM:
"Index investing is only passive in that there's no fund manager involved — it's actually a momentum-based strategy. Money going into index funds is allocated based on market weight, meaning the biggest companies get most of the inflows, boosting their share prices further."
How the Self-Reinforcing Loop Works
- Capital flows to market-cap-weighted indices
- Largest companies receive disproportionate inflows
- Their stock prices rise
- Market cap increases → index weight increases
- More capital flows → repeat
This creates a positive feedback loop that has driven extraordinary concentration:
| Year | Top 5 S&P Companies | Contribution to Return |
|---|---|---|
| 2024 | Fab Five (tech) | 44% of S&P return |
| 2024 | Nvidia alone | 21% of S&P return |
Why This Distorts Markets
No Quality Filter
Momentum/index allocation ignores:
- Return on capital
- Profit margins
- Competitive advantages
- Valuation
A company could have terrible economics and still attract massive capital flows if its market cap is large enough.
Flow Creates Distortion
"It's not just the percentage of assets in passive funds that causes distortion, but the flow between active and passive. When you move money from active funds holding Nvidia to index funds with high Nvidia exposure, Nvidia's stock price rises."
This means the process of moving from active to passive itself moves prices.
Concentration Creates Fragility
When returns are highly concentrated in a few companies, any rebalancing or capital withdrawal has outsized effects.
The Passive-Momentum Paradox
Despite being called "passive," index investing:
- Is the most popular momentum strategy
- Creates the largest flows to the biggest companies
- Drives prices further from fundamentals
- Requires constant inflows to sustain
Related Concepts
- passive-investing — The broader category
- quality-investing — What momentum ignores
- moat — Quality factors that should matter
Famous Quotes
"Index investing is only passive in that there's no fund manager involved — it's actually a momentum-based strategy." — Terry Smith
"The flow between active and passive funds itself causes severe market distortion." — Terry Smith