Market observers may have noticed that performing stocks typically tend to keep outperforming for a period while those underperformers keep falling behind. Exchange traded fund investors can also capitalize on this phenomenon through a momentum strategy.
“Winners over the past six to 12 months tend to continue to outperform for the next several months, while those that have underperformed often continue to lag,” according to Morningstar analyst Alex Bryan. “This phenomenon is known as momentum. It has been observed in nearly every market studied and across different asset classes over long periods.”
While investors should theoretically trade on new information and efficiently price markets, momentum strategies have still worked. Behavioral finance argues that investors tend to hold onto their beliefs and are slow to update views in response to shifts in the market. For instance, companies that have beat earnings estimates typically outperformed long after they announced results.
ETF investors can capture the positive momentum through the iShares MSCI USA Momentum Factor ETF (NYSEArca: MTUM), which tracks large- and mid-cap U.S. stocks with relatively high price momentum. The underlying MSCI USA Momentum Index calculates the ratio of each stock’s price returns over the trailing 13 and seven months against volatility over the past three years. Companies are then weighted by their risk-adjusted momentum. [Expanding Economic Conditions Should Favor Growth Stock ETFs]
“Risk-adjusted momentum gives a better signal of directional price movements, which may be more likely to persist,” Bryan added.
Additionally, the underlying index reconstitutes holdings only twice per year in May and November, and includes a broad buffer to diminish turnover and potential transaction costs.
Potential investors should be aware that the momentum strategy typically works well under sustained market rallies and could breakdown during volatile conditions. For instance, the underlying benchmark underperformed the MSCI USA Index by 3.8% during the 2008 financial crisis.