Virtus Introduces A Quality Momentum ETF

A new perspective on the growth vs. value debate.

Reviewed by: Virtus Investment Partners
Edited by: Virtus Investment Partners

[This ETF industry perspective is sponsored by Virtus Investment Partners.]

One of the hottest financial debates this past year has been whether value will finally outperform growth. Choosing factors can be tricky, but an ETF launched in November aims to make this decision easier. The Virtus Terranova U.S. Quality Momentum ETF (JOET) selects stocks based on quality and momentum in a rules-based manner, while remaining agnostic on the value versus growth debate. JOET has already attracted more than $90 million in assets under management.

Joe Terranova is chief market strategist for Virtus Investment Partners, which has more than $116 billion in assets under management. Here he discusses the timely questions JOET intends to address when it comes to competing factor choices, and how this fund was built with longer-term investors in mind. What problem does JOET attempt to solve?
Joe Terranova: The Terranova U.S. Quality Momentum Index doesn't aim to be a solution to the growth versus value debate; instead, it offers a compelling alternative by focusing exclusively on harvesting carefully targeted returns from factors that are highly relevant in today’s modern market.

It strives to identify proper strategies within the market. There’s been this binary debate over growth and value.

We tend to correlate growth to momentum. We think about growth stocks, and then we think about stocks that tend to have momentum. Unfortunately, the investment community seems to have rejected this perception of momentum from a factor strategy standpoint, because it’s correlated it to high volatility.

Momentum is a quantitative-based strategy that I believe is going to become more and more prevalent. Momentum equates to confidence. I want to invest in confidence.

Momentum equates to the player on the basketball court who hits four shots in a row. That player wants the ball so he can take the fifth or sixth shot. Another player, who has missed four shots in a row, generally does not want to take that shot; they're not playing with confidence.

But I needed something more than momentum. And that's where quality was introduced in the conversation.

I would hear “value” all the time being spoken about on CNBC. Well, what does value mean? Low pricing? That's how a lot of people view value; it's the antithesis to momentum, where we think high volatility. We think about stocks that are in a downtrend. But I thought, let's replace the word “value” with “quality.”

The rules-based methodology is straightforward. In the first step, in a momentum screen, the index starts with a universe of 500 of the largest U.S. companies and reduces it to 250 based on the technical trend (momentum) over the past 12 months.

In the second step, in a quality fundamental screen, that list of 250 stocks is narrowed to 125 by grading three equally weighted quality criteria (return on equity, debt to equity and annualized sales growth over the prior three years). The remaining 125 stocks are all weighted equally with a 0.8% weight upon rebalancing. Equal weighting also helps to remove overconcentration (idiosyncratic single-stock event risk).  

Index reconstitution and rebalancing of the basket of 125 stocks occurs quarterly right after earnings season (late October, late January, late April, late July), so quality metrics are as recent as possible.

It's a simple agnostic approach to the ongoing growth versus value debate, while focusing on the factors that are highly relevant to quantitative-factor-based investing in today’s market: quality and momentum. Even better, quality and momentum factors, when combined, can contribute to a significant overall reduction in volatility (momentum strategies alone can have significant volatility). So you’re combining momentum with quality?
Terranova: Let's take these two factors together and present them as one, to find the highest conviction opportunity we can for a core equity holding in a portfolio.

It’s my belief that we've introduced a better index. After all, the S&P 500 total return is up a little more than 14% year to date; 40% of the stocks in that index are actually lower on the year.

In other words, the S&P 500 has evolved into a very bifurcated index, and one, I would argue, that's becoming less and less efficient. As we speak today, 204 companies are lower on the year. We seek the highest-conviction opportunities to create a better index. And that's what the combination of momentum and quality presents.

We use equal weighting because we never want overconcentration or single-stock event risk. As mentioned, we rebalance and reconstitute quarterly. It’s a rules-based, intuitive and nonemotional strategy. Can JOET be a core equity holding?
Terranova: It’s my belief that it can be used as a replacement or complement to a core equity holding. I think it’s really important for investors to understand that momentum and quality have diversifying characteristics that may help provide for a compelling long-term holding. What worries about the future using this methodology?
Terranova: That someday I meet an investor who tells me that they incorporated the strategy into their portfolio and it didn’t meet their intended objective. This strategy only succeeds if it meets the investment expectations of the end user. From where are you attracting your investors?
Terranova: We believe we’re attracting investors seeking a modern index strategy. Those who are overly reliant on traditional cap-weighted strategies, those seeking to replace their underperforming large core/blend strategies, or those who are looking for a replacement for traditional trend-following/momentum strategies that exhibit higher levels of cyclicality and volatility.

There's a simplicity to it that I think adds to the elegance of the product, since complexity can be an obstacle for many investors. This very simple strategy affords investors a clear and transparent approach to equities.

Also, in the creation and development of the index, I was thinking about the younger generation of investors that’s just entering the financial world. I was thinking that there is a dramatic imbalance as it relates to the supply and demand of investable assets.

Let me just explain that for a second. The availability of investable assets has declined over the last 15 years. We've tried to introduce new asset classes. We largely failed. Availability of publicly traded companies has declined. Yet we have rising demand as millennials (aged 24-39) have replaced baby boomers (aged 56-74) as the largest living adult generation in the United States.

More and more millennials and Generation Z (aged 11-24) are going to embrace investing. So what I've attempted to do is provide some supply that aligns itself with characteristics these younger generations tend to appreciate; namely, technical trends, balance-sheet strength and high-conviction opportunities. They’re culling the losers.


Exchange-Traded Funds (ETF): The value of an ETF may be more volatile than the underlying portfolio of securities it is designed to track. The costs to the fund of owning shares of an ETF may exceed the cost of investing directly in the underlying securities. Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk. Momentum Factor Investing: Momentum investing is subject to the risk that the securities may be more volatile than the market as a whole. There may be periods when the momentum style of investing is out of favor, and therefore the investment performance of the Fund may suffer. Passive Strategy/Index Risk: A passive investment strategy seeking to track the performance of the underlying Index may result in the fund holding securities regardless of market conditions or their current or projected performance. This could cause the fund’s returns to be lower than if the fund employed an active strategy. Market Price/NAV: At the time of purchase and/or sale, an investor’s shares may have a market price that is above or below the fund’s NAV, which may increase the investor’s risk of loss. Correlation to Index: The performance of the fund and its index may vary due to factors such as fund flows, transaction costs, whether the fund obtains every security in the index, and timing differences associated with additions to and deletions from its index. Market Volatility: Local, regional or global events such as war, acts of terrorism, the spread of infectious illness or other public health issues, recessions or other events could have a significant impact on the portfolio and its investments, including hampering the ability of the portfolio manager(s) to invest the portfolio’s assets as intended. Prospectus: For additional information on risks, please see the fund’s prospectus.

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