Making the most of momentum ETFs

“Our goal in general is to offer the highest exposure to the factor we’re trying to track,” said Andrew Clee, vice-president of product at Fidelity Canada, whose lineup includes other factor-based strategies such as high quality, low volatility and value. Clee said they and the momentum ETFs are designed to “behave based on the factor and not an unintended bias.”

Taking what it describes as a more diversified approach to momentum is CI Global Asset Management, which like Fidelity competes in three equity categories. CI’s newest offering is the CI U.S. Enhanced Momentum Index ETF, which launched on Jan. 16 and is available in currency-hedged and unhedged versions.

The ETF is based on an index created and maintained by New York-based VettaFi LLC, which in January became a wholly owned subsidiary of Toronto-based TMX Group Ltd. VettaFi’s methodology has a 60% weight in price momentum, 20% in earnings momentum and 20% in quality metrics including profitability and debt coverage.

“While single-factor strategies have been shown to outperform over the long term, they can also be susceptible to prolonged periods of underperformance,” said Jaron Liu, director of ETF strategy with CI GAM. “A multi-factor approach has been shown to also lead to improved portfolio diversification without sacrificing outperformance.”

By comparison, the methodology behind Fidelity’s momentum ETFs is weighted 70% to price momentum, 15% to earnings surprise and 15% to eliminate stocks that have high levels of short-selling interest.

As Clee explained, the short-interest screen is meant to avoid stocks subject to a short-selling squeeze that would show up as strong momentum. “And then those stocks could come back to reality.”

Other elements of the Fidelity methodology include capping sector exposure to no more than 7% above or below its market weight, and adjusting stock weightings so the overall market capitalization of the portfolio replicates the broad market in which the ETF invests.

Clee said by minimizing exposure to other factors such as value, growth, low volatility and small-cap, what results is pure-play exposure to the momentum factor. “We feel that’s a very useful tool from a portfolio construction standpoint.”

An attractive aspect of the momentum factor is that it’s style-agnostic, Clee said. Since momentum follows the performance of stocks, a momentum fund can sometimes have characteristics of a value portfolio, while at other times looking like growth or even low volatility. “It’s not biased and it’s not stuck in its ways from an investment style standpoint.”

The idea behind momentum investing is stocks that have recently outperformed will continue to outperform, while those that have underperformed will do so. But this doesn’t necessarily account for company fundamentals, “and that can also potentially lead to investing in riskier and riskier stocks,” Liu said.

CI’s approach to momentum, he added, is to “try to provide that right balance between quality companies that have some sound fundamentals, while at the same time still getting the majority of that exposure to the momentum factor.”

CI’s new momentum ETF has created duplication with the 10-year-old CI Morningstar US Momentum Index ETF, which also has currency-hedged and unhedged versions. CI is seeking investor approval to merge the older ETF into the new one.

Performance isn’t the issue with the Morningstar U.S. ETF, which is currently the only momentum-factor ETF in any category in Canada to have the top Morningstar rating of five stars for risk-adjusted historical returns.

But the new CI ETF is cheaper, with a management fee of 30 basis points, or half what the Morningstar-driven one charges, and is also more broadly diversified. Liu said the new ETF has exposure to 200 names, or twice as many as the Morningstar index product.

Two other Morningstar-powered ETFs — CI Morningstar Canada Momentum Index ETF and CI Morningstar International Momentum Index ETF — remain in the CI lineup. The Morningstar momentum indexes are based primarily on stock-price movements, along with earnings revision, earnings surprise and trailing return on equity.

Momentum, which does well when stocks are on the rise, also has the potential to outperform in slumping markets. “Momentum investing is essentially trying to identify those winning stocks that are showing strength, and also sell off the losers,” Liu said. “That concept applies even during bear markets when market sentiment is negative.”

However, the momentum factor tends to perform poorly when a market trend reverses. “Momentum strategies like trending markets,” Clee said. “Sideways or volatile markets or changes in [market] leadership do not favour momentum strategies.”

Performance trends in momentum investing, like the economy itself, are cyclical. Historically, the most profitable times for the strategy tend to be after an economic recovery is well under way.

Over the past 12 months ended Feb. 29, which has seen large-cap growth stocks like some Magnificent Seven names leading the way, most momentum ETFs delivered robust double-digit returns.

“As you get to mid- or late-cycle, leadership tends to establish itself.” Clee said. “Momentum picks up the trends and it tends to do very well.”

The overall performance picture, however, is mixed historically. Risk-adjusted past returns of nearly all momentum ETFs are either average or below average, according to Morningstar.

Combined assets of all momentum ETFs currently total about $1 billion, of which more than half is held in the $562-million CI Morningstar Canada Momentum Index ETF, a Morningstar three-star performer. So far, as a group, momentum ETFs have had little sales momentum.