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What Is A Momentum Factor ETF?

Momentum Factor ETFs are a good place to start for beginner investors; however, if you want to take control of your portfolio, building your own momentum strategies can open up a world of possibilities. A tool like Composer can help manage and automate the complexities of momentum trading, making investing a snap.

Price trends are momentum

Think of momentum as a boulder rolling downhill. After an initial push, the force of gravity will pull the rock and help it pick up speed. Even once the hill levels out, some of that stored up energy remains to keep things moving in the short term.

Momentum factor ETFs look to capture this tendency in the stock market in ways that enable momentum investors to access investment strategies that take advantage of asset price changes. While assets like mutual funds, individual securities, and ETFs can be used as part of broader momentum investing strategies, momentum factor ETFs are targeted, single-strategy products that seek to isolate returns from momentum. The question is whether these momentum factor ETFs are better than other forms of momentum investing.

But first, let’s look at what exactly the momentum factor is that these exchange-traded funds are looking to leverage.

What is the momentum factor?

Let your winners ride is a common saying among investors because it’s true, and is an example of the momentum factor in action. Winning stocks, more often than not, will continue to perform well until something else changes their trajectory. Momentum benefits from momentum, including broader market uptrends.

Think about it this way: The momentum factor describes the tendency of well-performing stocks to continue outperforming, as well as those that are lagging to continue underperforming. Pricing trends in the stock market can and do change, but investors are often slow to incorporate new information or update their market views. The momentum factor captures this reality. There are several explanations for why momentum exists in markets which we explored in Reasons Momentum Trading Works.

And momentum can be seen across all asset classes and market capitalizations, small cap to large cap, from the Nasdaq to the Dow Jones Industrial Average and beyond. When the momentum factor is in favor, total returns from this investing style can exceed broad market benchmarks. Of course, these forces don’t last forever and, on average, asset prices that have benefited from the momentum factor tend to fall back down to the mean over the long term, but not until posting some solid capital gains. Price momentum is a fact of life for traders and investors, but an understanding of the momentum factor and how it can impact asset prices is a good place to start learning about how to use these forces in a trading strategy.

Direct investing in momentum strategies vs. using an ETF

As mentioned, a wide variety of different asset classes can be used to build a momentum investing strategy. At its core, momentum trading simply requires paying close attention to so-called momentum indicators — technical trading signals in the market that tell a trader when to buy and sell — and executing trades when signals or rules are triggered. These indicators can indicate buys or trend reversals that should be sold.

To do this effectively, momentum traders need to analyze uptrends and identify stocks that they believe have the momentum factor on their side. Then, with those targets in mind, use data to plan out an investing strategy that outlines exactly when to sell and what factors will contribute to that decision.

It can be a fairly manual, hands-on process.

As an investor, you may be watching a wide range of momentum indicators — from simple pricing changes, Rate of Change (ROC), Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), to even Stochastic Oscillators — looking for signals and metrics that tell you what to buy and when. And you also need to understand how the different momentum indicators work together, what they’re telling you, and what it all means for your target holdings. For more on momentum indicators, check out 5 Best Momentum Indicators for Retail Investors.

It’s a lot, and it takes some experience to get right.

But a momentum investing strategy can be a valuable addition to any portfolio. A recent study by the CFA Institute found that momentum strategies generate “long-term excess returns for investors,” to the tune of 0.4% monthly above the broader market. That’s based on data backtested from as far back as 1801. One solution for beginner investors interested in tapping this outperformance, then, is the momentum factor ETF. These exchange-traded funds were created to make it easy for investors to access the momentum factor in their own portfolios without having to do the manual research and analysis themselves.

The largest momentum factor ETFs (by AUM)

  • iShares MSCI USA Momentum Factor ETF (MTUM): The iShares MSCI USA Momentum Factor ETF seeks to track the investment results of an index composed of U.S. large- and mid-cap stocks exhibiting relatively higher price momentum. Its momentum index-based approach allows traders to manage overall exposure and risk within their momentum stock allocation portion of their portfolio. It has $9.64B in AUM.

  • Invesco DWA Momentum ETF (PDP): Based on the Dorsey Wright Technical Leaders momentum index, PDP is designed to identify companies that “demonstrate powerful relative strength characteristics.” It has roughly $1.16B in assets under management.

  • Invesco S&P MidCap Momentum ETF (XMMO): With a focus on mid-cap stocks, XMMO tracks the S&P Midcap 400 Momentum Index, investing in the 80 securities in the index with the highest “momentum scores,” calculated by measuring the upward price movements of each security as compared to other eligible stocks within the index. It has about $966M in assets under management.

  • iShares MSCI Intl Momentum Factor ETF (IMTM): IMTM was designed by Blackrock to track index of international developed large- and mid-capitalization stocks, all of which are exhibiting “relatively higher momentum characteristics.” It has $786M in AUM.

  • Invesco S&P SmallCap Value with Momentum ETF (XSVM): For investors looking to target small-cap stocks with their momentum strategies, XSVM targets the S&P 600 High Momentum Value Index and the 120 securities that have the highest "value scores" and "momentum scores.” It has $678M in AUM.  

  • Honorable mention: Vanguard U.S. Momentum Factor ETF (VFMO) with $220M in AUM and Cambria Global Momentum ETF (GMOM) with $124M in AUM.

Be sure to review each ETF's prospectus and evaluate its expense ratio and liquidity before investing. And remember, when reviewing returns, past performance is no indication of future success.

Pros and cons of momentum factor ETFs

If you are looking for an off-the-shelf investment strategy, Momentum factor ETFs have some advantages:

  • Tax efficiency: ETFs can often provide tax benefits that are difficult to duplicate when investing directly. That’s because ETFs are, by design, far more tax efficient than other funds.

  • Simple rebalancing: Most momentum investment strategies require periodic rebalancing to ensure that the portfolio reflects current momentum trends. But, with a momentum factor ETF the investor doesn’t have to worry about that, since the provider does it for you.

  • Set it and forget it: Since momentum factor ETFs take the day-to-day management of the strategy off of your plate, you could theoretically set it and forget it without having to worry about constant analysis and rebalancing.

That said, especially for sophisticated investors, there are some major drawbacks to this simplified approach to momentum investing:

  • Infrequent rebalancing: ETF providers typically don’t rebalance their holdings very often, in part to maintain their tax efficiency, which can limit their reactivity to the market. Momentum Factor ETFs can miss important moves in the market.

  • Stale holdings: At the same time, that limited rebalancing can leave older holdings in the fund for longer than might be optimal.

  • No customization: The set-it-and-forget-it nature of momentum factor ETFs can also play against investors who are looking to customize their trading portfolios.

So how can savvy investors manage momentum indicators, create trading rules for their portfolio, and customize their investment universe? Composer makes that simple.

Building a momentum strategy using Composer

While momentum factor ETFs make it easy to access the momentum factor, Composer makes it easy to build and automate custom momentum strategies. It’s almost like having your own personal ETF.  With Composer, you can customize the investment universe beyond what’s available in many ETFs and even choose your rebalancing schedule, all while automating your trades. Or, select from the existing momentum strategies available on Composer without giving up these advantages. Check out 5 Momentum Strategies to Consider in our blog.

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