Momentum Investing - Is the Trend Still Your Friend?

According to Sam Stovall, S&P Capital IQ U.S. equity strategist, from 1991 through 2015, the S&P 500 recorded a compound annual growth rate (CAGR) of 7.6%, excluding dividends reinvested. An equal weighting of the three best performing S&P 500 sectors from the prior calendar year, however, recorded a CAGR of 8.4%, and posted a 68% frequency of outperformance, or batting average of beating the market.

Yet the three worst prior-year performers saw below-market CAGR of 6.8% in the subsequent year, and beat the S&P 500 only 40% of the time. Therefore, history says that on a sector level, investors are advised to let their winners ride, rather than trying to buy low, with the intent of selling high later on.

In 2015, a number of multi-factor based ETFs were launched by established providers such as iShares and new entrants such as Goldman Sachs. These ETFs include momentum screening along with quality, size, value and other security specific attributes in an effort to offset the impact of one factor not working during the time period an ETF is held. But some investors might want an ETF that just focuses on momentum, given the aforementioned sector record.

In early January, iShares MSCI USA Momentum (MTUM) had a 30% weighting in consumer discretionary stocks, led by (AMZN). Technology was the second largest sector (25% of assets). But consumer staples (16%), and not health care (12%), was the third largest sector for MTUM. Altria (MO) was one such holding in the fund. The ETF ranks favorably to S&P Capital IQ for the above-average Quality Rankings and the relative strong Standard & Poor's Credit Ratings of its holdings and based on our technical analysis.

Meanwhile, energy, materials and utilities shares made up a combined 2% of assets, well below the 12% in the S&P 500 index. MTUM has $1.1 billion in assets and trades approximately 270,000 shares on a daily basis. The ETF has a low 0.15% expense ratio. The MSCI index behind MTUM's construction is generally rebalanced on a semi-annual basis, using six and 12-month risk-adjusted momentum criteria. However, the index can undergo "conditional ad-hoc rebalancing" based on changes in monthly volatility measures if triggers are hit, according to MSCI.

A second momentum ETF, PowerShares DWA Momentum Portfolio (PDP), which is tied to Dorsey Wright, a well-known technical analysis firm., PDP was more diversified at the sector level than MTUM, with less exposure to the top-performers of 2015 and more toward the laggards. PDP is reconstituted and rebalanced on a quarterly basis using a proprietary screening methodology that starts with stocks within the NASDAQ US Benchmark index.

Consumer discretionary (21% of assets), industrials (16%) and health care (15%) were the largest sectors. However, materials (7%) stocks were much more represented here than in MTUM. PDP also ranks favorably for the above-average Quality Rankings of its holdings, but has neutral technical trends.

We think both PDP and MTUM need to be regularly monitored to understand their exposures as turnover rates were 73% and 106%, respectively. Neither paid out a capital gain in 2015.

For investors seeking access to Dorsey Wright's analysis, First Trust Dorsey Wright Focus 5 ETF (FV) may be worth a look. But unlike, MTUM and PDP that hold stocks within a broader index exhibiting favorable momentum attributes, FV screens for First Trust sector and industry ETFs. Exposure to health care, through First Trust NYSE Arca Biotechnology (FBT) and First Trust Health Care AlphaDex (FXH) were a combined 46% of assets, with First Trust Dow Jones Internet (FDN) was 21%.

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