Put simply, stocks that are showing strong trends tend to maintain that outperformance as more investors become aware of the story. Relative performance is often reason enough to lure in more buyers and extend the existing motion that is already in place.
It should come as no surprise that there are a number of exchange-traded funds that seek to isolate this factor in a diversified basket of stocks. The first generation of which are based on passive indexes with rules-based criteria to identify top performers.
The PowerShares DWA Momentum Portfolio (NYSE:PDP) and iShares Edge MSCI USA Momentum Factor ETF (NASDAQ:MTUM) are two examples of this index strategy. Both funds seek to own a diverse mix of large and mid-cap U.S. stocks that are showing a high degree of relative strength. PDP owns 100 companies across a broad range of sectors, while MTUM carries exposure to 120 stocks. Each index has minor nuances in how it calculates and ranks momentum as well as how the components are weighted and rebalanced.
As is the case with many areas of the investment world, two data-driven ETF sponsors have set out to build a better mousetrap using the momentum factor as a jumping off point. Both have opted for an active structure to provide greater freedom in constructing and maintaining the overall portfolio. As such, we can compare the strengths and weaknesses of each alongside their underlying investment thesis.
The first active fund to debut in this category just celebrated its one-year anniversary. The Cambria Value and Momentum ETF (NYSE:VAMO) was conceived by Mebane Faber and Eric Richardson of Cambria Investment Management, LP. VAMO seeks to isolate 100 U.S. stocks based on a combination of value and momentum characteristics. The portfolio casts a wide net to include small, mid, and large-capitalization companies as part of its total market strategy.
Furthermore, VAMO has a rules-based, tactical hedging component built-in as well. This allows the ETF to expand an embedded short position in a diversified index such as the S&P 500 to potentially reduce volatility or protect against downturns. This ETF charges a net expense ratio of 0.59% to maintain the strategy.
It’s worth noting that despite the “active” moniker, the VAMO portfolio managers use quantitative screens to select the underlying stocks rather than gut feelings or cognitive biases. Value is typically measured over longer time frames such as 5-10 years, while momentum characteristics are drawn from a shorter duration that is typically less than one year. They can also adjust the underlying holdings and weights on a flexible time schedule to add or remove stocks that may no longer be adhering to the required portfolio characteristics.
The second fund taking an active path in the momentum category is the MomentumShares U.S. Quantitative Momentum ETF (BATS:QMOM). This ETF was developed by head portfolio manager Wesley R. Gray, Ph.D of Alpha Architect. QMOM seeks to take a more focused approach by owning just 50 U.S. stocks that are primarily mid and large-cap in size.
Within the portfolio construction criteria of QMOM are three different data-centric momentum screens. The first is a generic screen for trailing 12-month returns. Then comes a momentum quality screen for determining stocks with a smoother path of outperformance. Lastly, a seasonality screen is implemented that allows the portfolio to determine the most optimal times for rebalancing.
At present, each underlying position carries an equal weighted distribution of capital within the portfolio. This concentrated approach is a potential risk and advantage that investors will have to weigh in the evaluation of this fund. It will likely be a key driver in the shaping of performance and volatility (both positive and negative) over the course of its existence.
QMOM currently has $23 million in assets under management and charges a net expense ratio of 0.79%. This makes it one of the more expensive funds when compared to both active and passive peers in its category. Nevertheless, the unique nature of the portfolio and systematic approach that the manager implements may justify this greater cost.
The relatively short existence of both active funds in this category makes for a difficult performance comparison versus suitable benchmarks. Factor-based strategies, and particularly active funds, can often experience periods of divergences from both the broad market and their respective peers. Additionally, the implied value proposition of these ETFs likely needs a full market cycle to demonstrate meaningful results. It’s expected that a clearer picture will emerge as time goes on.
The Bottom Line
Momentum-based ETFs are designed to thrive in environments that favor stocks with strong fundamentals that show consistent relative price gains versus their peers. Conversely, they will struggle in trendless markets or during periods of time where sector rotation constantly promotes new leaders to the top of the pack.
The options listed above may be suitable for ETF investors that are seeking to tilt their portfolio towards stocks exhibiting solid relative performance. Additionally, they build on the work of world-class investment professionals with evidence-based strategy implementation.
This article is brought to you courtesy of FMD Capital.