This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Scott Kubie, chief investment strategist at Omaha, Neb.-based CLS Investments.
April 16, 2013 will likely be noted as a landmark day for ETFs.
On that day, iShares launched three ETFs tracking MSCI indexes related to the factors of size, value and momentum.
While ETFs of each type of fund existed prior to the launch, the three ETFs launched in mid-April have increased investor access to factor-based ETFs. Each of the ETFs launched that day have merit, but the most compelling of the three is the iShares MSCI USA Momentum Factor ETF (MTUM | D-64).
While the value and size ETFs offer some distinct advantages, there were already a plethora of tools able to tilt a portfolio toward lower capitalization and value securities.
The number of ETFs targeting momentum is significantly smaller. Momentum hasn't been as widely embraced by ETF providers, so MTUM's launch created more opportunity for investors.
MTUM also is attractive because of its low 0.15 percent expense ratio, or $15 for each $10,000 invested. That expense ratio is in line with existing large style ETFs, and was lower than the expense ratios of many ETFs using alternate weighting schemes.
Momentum as a style finds its roots in academia. In 1997, Mark Carhart published a seminal paper describing how stocks with positive momentum outperformed after adjusting for the market risk as well as the size and value factors emphasized by Eugene Fama and Ken French.
As the momentum factor gained additional support, investors sought to understand its nature. Cliff Asness suggests using momentum as a replacement for the growth style box:
"Frankly, we believe that momentum is correlated to growth, but that it's a better style. Growth being the opposite of value means it has a negative passive premium, a negative long-term premium. Momentum, like growth, is negatively correlated to value but has a positive premium over time."
Statistics back up the comparison. The differences between MTUM and the MSCI USA Index are generally much wider than the differences between MTUM and the MSCI USA Growth Index.
The only valuation ratio where the broad index is closer than the growth index is the price-to-sales ratio. Investing in momentum doesn't force the investors into a big overweight in lower capitalization stocks. MTUM's market cap is only 9 percent below the broad index and just 2 percent below the growth index.
Considering small-cap stocks have done well, this is impressive.
|iShares MSCI USA Momentum Factor ETF…||P/E||P/B||P/S||P/C||Average Market Cap.|
Relative to MSCI USA
Relative MSCI USA Growth
Sources: CLS Investments, Morningstar Direct
MTUM's sector exposure also matches up well with growth. The top sector weightings are health care, consumer discretionary and technology, all of which are associated with growth.
However, momentum is not without its detractors. Momentum strategies receive criticism because they tend to chase the market.
When the market goes up, stocks with higher risk often do better, giving them the best momentum. When the market goes down, the advantage swings to less risky stocks. When applied in this fashion, momentum becomes a proxy for chasing the overall market trend.
The approach used in the index behind MTUM overcomes this challenge. Initially, performance is evaluated over two different time periods. Then the excess return is adjusted by the volatility of the security.
Adjusting momentum by risk lessens the impact of market direction on what securities are selected. For example, if a stock with 50 percent more risk than the market outperforms the market by 25 percent, it would have a very positive trend. But how does it compare with a stock with performance equal to the market, but is only 75 percent as risky?
If based on straight momentum, the first stock is doing the best; the methodology of MTUM favors the less risky security performing in line with the market.
Also, the ETF structure provides potential tax advantages over applying a momentum approach to a group of securities in a portfolio. Momentum strategies generally focus on shorter-term trends. MTUM uses six- and 12-month horizons to evaluate trends and rebalances every six months.
Applying this strategy to securities held in an account could potentially produce a fair amount of short-term gains. ETFs also have the ability to use the creation/redemption process to defer the taxes, putting the investor in an improved tax situation.
Buying an ETF for a momentum strategy also reduces the need for the investor to be responsible for the monitoring and trading of the portfolio. For time-starved investors, this is a big advantage.
Additionally, the ETF can efficiently focus on stocks rather than ETFs targeting a particular sector or style. Going one level deeper and owning the stocks will likely improve the overall momentum quality of the portfolio, thereby creating more efficient exposure to the momentum factor.
Performance so far has been neutral. MTUM's inception return through Jan. 14, 2013 is 18.25 percent, trailing slightly behind the iShares MSCI USA Index, which is up 18.73 percent. In the short time period since its launch, MTUM has lagged the comparable growth index by a little over 2 percent.
Despite growth's short-term outperformance, momentum appears to be an attractive replacement for some of the growth allocation in the portfolio. Momentum has solid academic support.
For investors who want to include momentum as part of their investment approach, using an ETF to access momentum will likely improve taxable performance and allow more time to focus on evaluating whether any of the historically strong factors, including momentum, have become stretched and are likely to underperform.
CLS Investments is an Omaha, Neb.-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact Scott Kubie at 402-896-7406 or at Scottk@clsinvest.com.
ETFs are investment companies aimed at achieving the same return as a particular market index. ETFs will invest in either all of the securities or a representative sample of the securities included in the index. Investing in ETFs involves risk. Please click here for a complete list of relevant disclosures and definitions.
At the time this article was written, CLS held MTUM in certain client portfolios.
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