The Principal U.S. Small-Cap Multi-Factor Index ETF (NASDAQ: PSC), as its name implies, is a multi-factor strategy and one of the factors represented in the fund is momentum. Recently, that’s been working in favor of investors.
PSC’s underlying benchmark, the Nasdaq US Small Cap Select Leaders Index, “uses a quantitative model designed to identify equity securities (including growth and value stock) of small-capitalization companies in the Nasdaq US Small Cap Index (the ‘parent index’) that exhibit potential for high degrees of sustainable shareholder yield, pricing power, and strong momentum while adjusting for liquidity and quality,” according to Principal.
PSC isn’t a dedicated momentum fund and that’s alright because the factor cuts both ways and can be punishing on the way down.
“Momentum exchange-traded funds take different approaches to portfolio construction, attempting to retain the benefits of the momentum factor in its purest form and address some of its potential drawbacks,” writes Morningstar’s Ben Johnson. “Navigating these nuances can be challenging. Having a solid framework for understanding them is critical.”
Momentum investing is rooted in the notion that securities that are on torrid paces will continue acting that way over the near-term while laggards will continue slumping. Long-term data for the momentum factor are compelling, but the factor can be volatile. PSC mitigates some of that turbulence by introducing shareholder yield to the equation, a strategy that adds a dash of quality to the portfolio.
“In assessing momentum strategies, investors should first make note of the selection universe. This represents the fund’s opportunity set: which stocks are in play and which aren’t,” notes Johnson.
Additionally, momentum investing can target those companies that are exhibiting high levels of growth. The momentum factor selects company stocks that have recently outperformed based on the idea that “the trend is your friend” and that stock market leaders typically continue to outperform. This type of strategy can be an effective way of targeting growth-oriented companies since stocks with positive momentum often continue to generate strong earnings.
Because PSC is a multi-factor approach, it has some advantages over pure momentum ETFs.
“Momentum was strong among the market’s biggest stocks during the tech bubble. When the bubble burst, momentum reversed violently. In recent years, we’ve seen large-cap momentum stocks outperform their smaller counterparts once again,” according to Johnson. “There is no sense in trying to time these shifts. Selecting a momentum fund that draws from the deepest well of stocks will increase investors’ odds of staying on top of momentum, wherever it may roam.”
For more on multi-factor strategies, visit our Multi-Factor Channel.
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.