ETF Trends
ETF Trends

Investors who believe that last year’s top performers can still maintain their lead ahead could look to momentum exchange traded fund strategies for 2016.

Sam Stovall, S&P Capital IQ U.S. equity strategist, found that from 1991 through 2015, the S&P 500 recorded a compound annual growth rate, or CAGR, of 7.6%, excluding dividends reinvested, writes Todd Rosenbluth, S&P Capital QI Director of ETF Research, in a note.

Stovall calculated that an equal weighting of the best three performing S&P 500 sectors from the prior calendar year resulted in a CAGR of 8.4% and posted a 68% frequency of outperformance. In contrast, the three worst prior-year performers saw below-market CAGR of 6.8% in the following year and only beat the S&P 500 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,” Rosenbluth said.

The momentum strategy basically bets that hot movers will continue to rise, so investors would buy high and sell even higher. Investors who want to follow this momentum strategy will be betting on outperforming sectors flying even higher. Among the top performers over the past year, consumer discretionary led with a 8.4% gain in 2015, followed by healthcare up 5.2%  and information technology up 4.3%.

Additionally, there are now a number of ETF strategies that specifically target the momentum strategy. For example, the iShares MSCI USA Momentum Factor ETF (NYSEArca: MTUM) 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.

MTUM includes a hefty 29.5% tilt toward consumer discretionary, along with 25.0% information tech and 12.0% health care. The ETF also underweights energy at 0.5% and materials at 1.0%, two of the worst performing sectors over the past year.

The Powershares DWA Momentum Portfolio (NYSEArca: PDP), which utilizes technical analysis from Dorsey Wright and picks out stocks based on relative strength, includes a slightly more diversified approach than MTUM, including less exposure to the top-performers of 2015 and more toward the underperforming areas. Top sector weights include consumer discretionary 20.8%, industrials 16.8%, health care 15.7%, financials 15.7% and information technology 14.0%.

Investors who favor Dorsey Wright analysis may also take a look at the First Trust Dorsey Wright Focus 5 ETF (NasdaqGM: FV),  which follows DWA’s relative strength ranking system where sector ETFs are compared to each other to measure price momentum relative to other ETFs in the universe and the top five ranking ETFs are included in the underlying index. Specifically, FV includes about a 20% tilt toward biotech, internet stocks, health care, consumer stales and consumer discretionary.

Potential investors, though, should be aware that the momentum strategy typically works well under sustained market rallies and could breakdown during volatile conditions. For instance, these ETFs sold off during the start of 2016 as broad markets slipped.

“While S&P Capital IQ’s ETF research does not rely on past performance, we think it highlights the importance of looking inside popular momentum ETFs to understand its drivers,” Rosenbluth added.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.