Momentum investing — based on the tendency of rising stock prices to keep going up in the short term — is a winning strategy in bull markets. What’s less known is that momentum criteria can also play a useful role in bear markets. While momentum investors let their winners run, the flip side of the strategy is being quick to dump holdings whose stock prices start to head south.
“Momentum tends to do well in a trending market,” says Antonio Picca, head of factor-based strategies with Valley Forge, Pa.-based Vanguard Group Inc., parent company of Toronto-based Vanguard Investments Canada Inc. “If the market is going consistently up, the momentum strategy will do well. If the markets are going consistently down, the momentum strategy will also do well.”
In the Canadian marketplace, four firms offer ETFs explicitly self-identified as momentum plays. The largest provider is First Asset Investment Management Inc., a subsidiary of Toronto-based CI Financial Corp. Along with Vanguard Canada, the other contenders are Toronto-based Invesco Canada Ltd. and a new ETF entrant, SmartBe Wealth Inc., which is based in Calgary.
The purest momentum play is the $31-million Vanguard Global Momentum Factor ETF. It’s one of four actively managed factor-based ETFs that Vanguard Canada launched on the Toronto Stock Exchange in June 2016. Its three key screening criteria — 11-month momentum, six-month momentum and risk-adjusted one-year momentum — are all strictly based on trends in stock prices. Holding about 900 names at the end of July, the ETF’s portfolio is monitored and adjusted daily in order to keep the momentum factor as robust and consistent as possible.
“We want to give investors access to what can be considered well-established factors in the academic literature. Historically the academic literature has come to agree on the fact price momentum is a manifestation of momentum that leads to a premium over a long period,” Picca says. By that, he means outperformance over a much longer period than the ETF’s real-life history. Its annualized three-year return of 8.6% to July 31, 2019 lagged that of the passively managed Vanguard FTSE Global All Cap ex Canada Index ETF, which returned 10%.
Though academic research suggests that a momentum strategy should outperform over time, Picca and his colleagues caution that it shouldn’t constitute the bulk of an individual investor’s portfolio. For those who are looking to outperform the broad market or diversify by investing in factor strategies, “the general advice we give investors is to use a combination of factors to achieve that. It could be value, momentum, liquidity, minimum volatility,” Picca says.
The most extensive lineup of momentum-style ETFs in the Canadian marketplace is First Asset’s suite of five ETF listings based on indices developed and maintained by Chicago-based Morningstar Inc. By far the largest is the $911-million CI First Asset Morningstar Canada Momentum Index ETF. The other four listings are U.S. equity and international equity ETFs, each available in either currency-hedged or unhedged versions.
Unlike the essentially pure-play Vanguard ETF, the First Asset ETFs also employ non-momentum factors. Stock-price momentum — measured over three, nine and 12 months — accounts for only 40% of the selection criteria. Another 30% is based on three-month earnings-per-share revisions, and 10% on the latest quarterly earnings surprise.
Finally, 20% of the screening is based on trailing return on equity, a metric unrelated to either stock price or earnings momentum. The First Asset ETFs also employ sector constraints to avoid overweighting in any one industry. Yet another deviation from the momentum strategy is that the First Asset ETFs, instead of letting their winners run indefinitely, rebalance their holdings to equal weightings every three months.
Peter Tomiuk, senior vice president, ETF strategy at First Asset, says the earnings criteria are intended to ensure that the majority of the ETFs’ holdings are profitable companies, or are doing better than expected in terms of earnings. These screens are consistent with companies that have earnings momentum. As for the return on equity screen, it adds a quality element to the portfolios. “The last thing we wanted,” says Tomiuk, “was someone to potentially be replacing a passive index ETF or an actively managed mutual fund to hold an ETF that in theory could have all its holdings with potentially no earnings.”
Of the First Asset momentum offerings, all of which hold mostly mid- and small-cap stocks, the strongest performer has been the Canadian ETF. Launched in February 2012, it holds a concentrated portfolio of 30 stocks. It’s a top-quartile performer in the Canadian equity category over the past three and five years ended July 31.
Notably, the Morningstar index on which the Canadian ETF is based has outperformed the S&P/TSX composite index in both rising and falling markets, according to data provided by First Asset. Its “up-capture ratio” was 111% for the period from Aug. 1, 2003, to July 31, which means the momentum index beat the market benchmark during rising periods. In declining markets, the “down-capture ratio” was 78%, meaning that the momentum index’s loss was less than that of the broad market.
“The majority of momentum mandates tend to show very strong performance in strong equity markets,” says Tomiuk. “But we’ve also seen a lot of evidence that one shouldn’t discount some of the downside protection characteristics of this style.”
A similar pattern of outperformance over the same period, in both rising and falling markets, was evident in the historical index returns for First Asset’s international equity strategy. It holds 200 names. But the U.S. momentum index, while outperforming in rising markets with its portfolio of 50 names, also had steeper losses than the S&P 500 index in falling markets.
Momentum investing can also be applied to tactical shifts in asset classes. An example of this approach is Invesco DWA Global Momentum ETF, which is available in currency-hedged, unhedged and U.S.-dollar units, The Invesco fund holds four underlying equity ETFs — representing U.S. large and mid-caps, U.S. small-caps, international developed markets and emerging markets. Based on methodology licensed from Richmond, Va.-based Dorsey Wright & Associates LLC, the Invesco ETF makes asset mix shifts according to the relative strength of each underlying fund, as well as U.S. treasury bills. Though it’s in the global equity category, the ETF could be entirely in cash.
Also having a market-timing element is the SmartBe Global Value Momentum Trend Index ETF, which tracks a Canada-focused index created by Philadelphia-based Alpha Architect LLC. Along with stock-price momentum and value criteria, the ETF incorporates a trend-following metric which is designed to shift the asset mix away from equities and toward lower-risk asset classes when the trend is negative. As of July 31, the ETF was 83% in equities, roughly equally divided between Canadian and non-Canadian holdings, with the remainder in short-term securities and cash.
A recurring theme among momentum ETFs is that the strategy works best in combination with other investment disciplines. This can be accomplished by making a momentum-style fund a component of a style-diversified portfolio, as advocated by Vanguard. Or, as with First Asset’s ETFs, momentum can be part of a multi-faceted screening process that employs other securities-selection criteria and risk-management constraints.