Factor Series: Momentum

Imagine a scenario where a long-lost, family favorite recipe was found, and you were requested to make the dish for an upcoming holiday. When reviewing the recipe, you notice the ingredients include a commoditized reference with no other details: “10oz of beef”.

This presents an issue since various cuts of beef offer different flavor profiles and textures, along with varying cooking times. Using the wrong cut of beef could change the entire dish, leaving your family highly disappointed in your cooking abilities.

Albeit a dramatic example, investing factors are very much like referring to cuts of meat with a generalized description like beef, chicken, or pork. While this works fine as a simple reference, a financial advisor or investor needs to know the specific “investing recipe” of their factor exposure; otherwise, the result may differ from what was expected.

Bottom line – don’t make Beef Wellington with cow tongue, and understand the details of fund factor exposures in your portfolios.

The first factor we’ll be exploring is momentum. The term is often misunderstood, and the calculation behind any given momentum ETF can be vastly different from product to product.

Defining Momentum

Before diving in deeper, let’s take a moment to briefly baseline our understanding of momentum and the general calculations commonly used.

  • Absolute momentum – measures a stock’s performance relative to itself, often using a years’ worth of data. If a stock’s price is higher than where it was 12 months prior, it would be said to exhibit positive momentum.
  • Relative momentum – measures a stock’s performance relative to other stocks, securities, indexes, etc. If a stock has outperformed its relative benchmark, it would be said to have positive momentum.

Note: these are just two general examples of momentum strategies. Some funds may combine both calculations, use screens to limit the stock universe, or consider alternative measures of momentum altogether – again, driving home the importance of understanding the specific criteria used for any ETF offering this factor exposure.

Dissection and Differentiation

To assist with the visualization of differences between Momentum ETFs, we’ll compare and contrast the following funds:

  • Alpha Architect US Quantitative Momentum ETF – QMOM
  • Invesco DWA Momentum ETF – PDP
  • iShares MSCI USA Momentum Factor ETF – MTUM
  • Virtus Terranova US Quality Momentum ETF – JOET

Descriptions and Objectives

Below are summarized descriptions based on the fund’s prospectus, fact sheet, and stated index methodologies.

Alpha Architect – QMOM

  • ETF Objective: Seeks to track the total return performance, before fees and expenses, of the Alpha Architect Quantitative Momentum Index
  • Index: Alpha Architect Quantitative Momentum Index
  • Eligible Investment Universe: Largest 1,500 US common stocks based on market cap
  • Index Methodology: While the end result is to have an equal-weighted index of 50 high-momentum equities, there are several elimination screens run prior to index reconstitution, including removing ADRs, REITs, and ETFs, as well as various negative, generic, and quality of momentum screens. Visit https://bit.ly/3zeJTVt for full index methodology details. 

Invesco – PDP

  • ETF Objective: Seeks to track the investment results (before fees and expenses) of the Dorsey Wright® Technical Leaders Index
  • Index: Dorsey Wright® Technical Leaders Index
  • Eligible Investment Universe: 1,000 largest securities by market cap within the NASDAQ US Benchmark Index, excluding ADRs
  • Index Methodology: Assign a relative strength score based on intermediate and long-term price movements to the 1,000 largest market cap securities in the NASDAQ US Benchmark Index. The top 100 highest scoring stocks are then weighted based on their score.

iShares – MTUM

  • ETF Objective: Seeks to track the investment results of an index composed of US large- and mid-capitalization stocks exhibiting relatively higher price momentum
  • Index: MSCI USA Momentum SR Variant Index
  • Eligible Investment Universe: US Large and Mid-cap Equities
  • Index Methodology: Risk-adjusted 6 and 12-month relative performance is calculated and assigned a momentum score. A fixed number of stocks with the highest momentum score are then market-cap weighted in the index.

Virtus Terranova – JOET

  • ETF Objective: The Fund strives to deliver exposure to US-listed large-cap companies that combine strong quality fundamentals with positive momentum technical trends.
  • Index: Terranova US Quality Momentum Index
  • Eligible Investment Universe: US Large-cap Equities
  • Index Methodology: Using the S&P 500 as a starting point, all equities are given a momentum score based on their total return over the previous 12 months. The top 250 equities are then given a quality screen based on return on equity, debt to equity, and sales growth rate. The 125 securities with the highest composite rankings will form the components of the index. Securities are equally weighted at each rebalance.

Equity Overlap

The description and index summaries drive home the beef analogy used earlier. All of these funds are categorized as momentum ETFs seeking to capture US equities with high momentum, yet the methodologies differ significantly.

What about the overlap of equities held in these funds? Even though the index methodologies are different, all four funds start with nearly the same US large-to-mid cap securities universe. There should at least be a high rate of overlap then, right? Not so fast.

The chart below offers a holdings comparison as of 01/05/22. There are only 6 stocks held by all four funds, 26 by three, 54 by two, and 188 in a single fund – implying a total equity overlap rate of only 2.1% for all four funds! Similar strategies, yet substantially different holdings.

Image
Source: ETF Action

Here’s how overlap looks from a fund vs. fund perspective:

  1. MTUM and QMOM: 17 stocks
  2. MTUM and PDP: 44 stocks
  3. MTUM and JOET: 43 stocks
  4. QMOM and PDP: 12 stocks
  5. QMOM and JOET: 8 stocks
  6. PDP and JOET: 44 stocks
Image 1
Source: ETF Action

Performance

Putting momentum methodologies and calculations aside, the rubber always meets the road on performance. A quick item to note – many of these momentum theories have been back-tested with years of data before methodologies were finalized. All of these funds were launched within the last seven years, with JOET being the most recent in late 2020. This lack of performance data may not paint an accurate picture of returns moving forward. Either way, let’s take a look at the 1, 3, and 5-year comparisons below.

Image 2
Source: ETF Action

With its large-cap-only exposure, JOET was the relative top-performer on a one-year basis (12/31/2020 – 01/05/2022). However, it’s worth noting that JOET still underperformed the S&P 500 (SPY), which was up >29% over the same time period.

Longer-term, the performance results become more interesting with QMOM’s relative outperformance on a 3-year basis and MTUM on a 5-year.

Rebalancing

A rules-based rebalancing tempo is a crucial part of the methodology with a strategy like momentum. Over a month, quarter, or even longer, stocks that previously had positive momentum could become stagnant with horizontal performance, or even a full downtrend. Rebalancing allows for a refreshing of the stocks held within the index/ETF, ensuring they exhibit current positive momentum.

Index Rebalancing Tempo

  • Alpha Architect – QMOM: Quarterly – End of Feb, May, Aug, Nov
  • Invesco – PDP: Calendar Quarter
  • iShares – MTUM: Semi-Annual – End of May, Nov
  • Virtus Terranova – JOET: Calendar Quarter

To visually depict how and why rebalancing is an important part of any momentum strategy, consider the below graph focusing on QMOM for the time period of 12/01/20 – 03/01/21. QMOM’s index was reconstituted in late November, with the ETF rebalancing soon after. Although this is another limited time period, QMOM’s methodology was a clear winner for this quarter, outpacing the other funds by nearly 20%.

Image 3
Source: ETF Action

Sector Exposure

The last cross-section we’ll observe is the current sector exposure in each ETF. While all of these funds are sector agnostic, a rational person might assume the exposures should be relatively close to one another. After all, momentum is momentum, right? Wrong! The graph below shows sector exposures for each fund, with several varying substantially. Take note of the energy and tech exposure of QMOM, along with the financials and industrials exposure of PDP. It’s interesting to note that all of these strategies are currently in alignment that there is no momentum within utilities.

Image 4
Source: ETF Action

Conclusion

While it’s easy to understand why investors might lump all of these strategies into the same commoditized “momentum” bucket, they are providing very different exposures on any given day. Investors should ensure they complete a thorough review of each fund before investing to ensure the exposure fits their “investing recipe.” Make sure your Beef Wellington is made with beef tenderloin filet!