Momentum ETFs: They'll Work Until They Don't

Exchange traded funds adhering to momentum strategies are delivering impressive returns this year and capturing more assets from investors.

The iShares Edge MSCI USA Momentum Factor ETF MTUM and the SPDR Russell 1000 Momentum Focus ETF ONEO are up 10.7 percent and 4.2 percent, respectively, year-to-date. Momentum investing is an easy concept to understand. At the center of this idea is that securities that have recently surged or tumbled will continue doing so. Momentum's focus on recent winners can make the strategy vulnerable when markets retreat.

What Happened

The momentum strategy itself, at least in theory, is sector-agnostic. Yet today's momentum ETFs are usually heavily allocated to the technology and consumer discretionary sectors. Those sectors combine for about 60 percent of MTUM's weight. ONEO devotes 35 percent of its weight to those two sectors.

“Typically, as factors become more popular, their excess returns are likely to diminish,” S&P Dow Jones Indices said in a recent note.

The more the market is dominated by value investors, the harder it is to find cheap stocks, according to S&P Dow Jones.

"But momentum is different: momentum-based strategies, by their nature, focus on the market’s recent winners.  Flows into those strategies may further inflate those winning stocks, which can attract (or convert) still more trend followers, and so on in an inflationary cycle.”

Indeed, investors are displaying a fondness for momentum ETFs this year. Year-to-date, MTUM has added $3.42 billion in new assets, a total surpassed by just eight other ETFs. ONEO has added $59 million of its $614.5 million in assets this year.

Why It's Important

ONEO is an equal-weight ETF, so it tilts toward smaller stocks. Combine the fund's consumer discretionary and technology exposure with the recent benefits of soaring smaller stocks, and ONEO is a momentum play that could be right for the current environment. Or one that will work until investors decide another factor offers better alternatives to momentum.

MTUM is no less vulnerable to momentum falling out of favor. A pullback in big-name internet and technology stocks — two of the four FANG stocks are MTUM top 10 holdings — could ding this ETF.

What's Next

The recent outperformance of the S&P 500 Momentum Index is elevated relative to historical norms and indicates investors may want to be cautious with momentum strategies.

“The relatively high current reading suggests, at a minimum, that caution may be in order,” said S&P Dow Jones. “Nevertheless, it remains a hard task to predict exactly when the trend might reverse.”

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