If picking what factor to invest in is tricky business because timing factors is practically impossible, and cyclicality means periods of underperformance relative to the market, picking a factor ETF can be just as difficult.
Consider two momentum funds. They both look for companies that have seen strong price gains in recent months and are likely to continue seeing gains ahead, but their diverse approaches to a similar universe mean very different results—sometimes.
The difference in performance between the iShares MSCI USA Momentum Factor ETF (MTUM)—the largest momentum ETF on the market—and the MomentumShares U.S. Quantitative Momentum ETF (QMOM) year-to-date is striking, as the chart below shows. There’s a divergence of 15.6 percentage points between them. In other words, MTUM has delivered roughly 350% of the returns QMOM has shelled out so far in 2017.
(For reference, the second-largest fund in this segment, the PowerShares DWA Momentum Portfolio (PDP), and the SPDR S&P 1500 Momentum Tilt ETF (MMTM), are found somewhere in between MTUM and QMOM in terms of performance. All but QMOM are outpacing the broader market as measured by the SPDR S&P 500 (SPY).)
There’s the basic portfolio construction differences to start with. Both MTUM and QMOM pick momentum stocks from the U.S. total equity market—they are fish swimming in the same pond.
But MTUM picks and weights stocks by looking at both six- and 12-month holding period returns, and it scales by the volatility of returns over the past three years. The fund essentially goes beyond a pure momentum factor capture by looking at various metrics in its effort to deliver a smooth ride in returns.
QMOM, meanwhile, takes a more classic approach to the momentum factor, targeting the 10% of stocks with the highest total return over the last 12 months, excluding the most recent month. The ETF also excludes stocks that have too many negative-return days during the 12-month period in a mix that’s equal-weighted.
These differences point to two key things. First, that the end result for MTUM is a portfolio that typically tilts toward lower-beta names and much higher market capitalization than QMOM. MTUM has a portfolio beta of 0.92 and a weighted average market cap of $143 billion; QMOM’s beta is 1.51 and has a weighted average market cap of only $16 billion, according to FactSet data.
Size Impacting Momentum
Given the performance disparity between these two funds this year, it’s safe to assume that size is having a significant impact on the momentum factor. At least Alpha Architect’s Wes Gray thinks so.
The firm’s research suggests that when you look at the top-decile momentum portfolio this year, a value-weighted approach is delivering nearly 15 times the returns of an equal-weighted exposure to the same group of stocks.
“The large spread between value-weighted and equal-weighted momentum results suggests there’s a strong ‘size’ component to momentum,” said Gray, whose firm runs QMOM.
Secondly, the methodologies result in very different sector tilts.
Technology—the best-performing sector in the S&P 500 this year—tops MTUM’s sector bets at 30%, followed by financials and consumer discretionary. These three sectors represent about 70% of the portfolio, with names like JPMorgan Chase, Bank of America, Microsoft and Apple topping holdings—mega-cap names.
Small/Midcap Slant With Equal Weighting
QMOM, too, allocates heavily to technology names—roughly 41% of the portfolio is tech. But it allocates less to financials at 16% versus 26% for MTUM, and consumer discretionary at 8% versus 13% for MTUM. On the other hand, QMOM bets bigger on industrials, which represent about 15% of the portfolio.
While the fund is equal-weighted, its largest holdings at about 3% are names like Clovis Oncology, Exelixis, and Dana Inc. Portfolio holdings weight around 2.5%.
“While both ETFs have a hefty weighting in the hot technology sector, the specific stock exposure is different,” noted Todd Rosenbluth, CFRA’s director of ETF & Mutual Fund Research. “MTUM has a higher weighted average market aided by healthy weightings in strong-performing Apple, Microsoft and Nvidia. Meanwhile, QMOM is equally weighted and has more of small/midcap slant.”
“MTUM also has a higher weighting in financials, particularly diversified banks; QMOM’s financial exposure is more tied to regional banks,” he added. “Stocks do not go up uniformly, based on a factor attribute, and an investor needs to understand what securities are inside.”
So far this year, investors have flocked to MTUM following its performance. The fund has seen more than $1.01 billion in net creations, making it one of the most popular smart-beta ETFs this year. The fund has more than $3.35 billion in total assets. QMOM, a much smaller ETF, with $35.5 million in assets under management, has attracted inflows of some $9 million year-to-date.
The Active To Passive Switch
What’s also anecdotally interesting here is QMOM’s back story.
The fund originally launched in 2015 as the segment’s only actively managed ETF. But this past January, QMOM, along with three other Alpha Architect ETFs, switched gears and began tracking an equal-weighted index. The active fund became a passive strategy.
According to Gray, the change from active to self-indexing took place for three reasons: “Because we were already operating that way; self-indexing affords more flexibility to minimize tax burdens and maximize shareholder benefits, and; it’s easier for investors to do due diligence since they can review the index methodology and dig in the weeds.” But QMOM’s recipe and its process didn’t really change at all, he says.
Still, if you go back and look at QMOM’s 2016 performance, it ran neck-and-neck with MTUM, the uncontested leader in the space, with $3.35 billion in total assets gathered in little more than four years.
The chart below shows these funds’ performance during calendar year 2016:
Charts courtesy of StockCharts.com
Coincidentally, the divergence between the two funds really got pronounced following the switch to passive.
But again, that is more of a testament about the reality of factor risk—sometimes they don’t perform as well. It’s also a testament about the impact different approaches to factor investing can have in different market environments, and what intended or unintended additional factor exposures (such as size) can mean to overall returns at different times.
Last year, there wasn’t much difference between the two funds’ performances, but this year, MTUM’s approach to momentum has worked wonders.
Contact Cinthia Murphy at firstname.lastname@example.org
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