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Over the past decade, the growth of the Exchange Traded Fund (ETF) industry has given investors a host of choices for completing their objectives. This is largely due to the many innovative strategies to suit investor preferences which are now available in ETF form (see A Primer on ETF Investing).
Exchange traded funds now enable investors to express a holistic view on a particular asset class/economy/sector under the wrapper of a single ETF product. Some of the recent innovative strategies embedded in ETFs include merger arbitrage, leverage, inverse leverage as well as a relatively new category but one that is already well known among many investors, momentum investing.
Momentum investing explained
Over the past couple of decades, momentum trading has become extremely popular among day traders and fund managers alike. The basic idea of momentum trading is to capitalize on the “rate of change” of individual stock price movements relative to the broader markets.
A momentum trading strategy involves the belief that, historically, stocks with faster price movement (i.e. momentum) relative to the broader market will continue doing moving higher, sort of a Newton’s first law for stocks. In other words, a stock that is moving higher tends to soar, while stocks that are slumping often have trouble breaking out of a negative channel.
Having said this, it is important to note that this tendency is ‘mean reverting’. This means that once the trend reverses, the stocks would start to move in the opposite direction at a faster pace than the broader markets.
In the light of this explanation, it becomes very clear that the key to success in momentum trading clearly lies in two things: Market Timing and Stock Selection (read New Small Cap Technical Leaders ETF (DWAS) Debuts). While there are a ton of fundamental as well as technical indicators that could assist in ascertaining the two key points mentioned above, the best strategy to ascertain the two would depend on the understanding and implimentation of momentum strategies by individual traders/fund managers.
Momentum ETFs in the Current Market Scenario
The present market environment is characterized by high levels of uncertainty and volatility. The slowdown in many of the emerging as well as developed nations has also injected heavy turbulence in capital markets.
Nor is it easy going on the domestic front. The poor 2Q12 GDP growth rate of 1.5% coupled with a rising unemployment rate and below-par earnings season (so far) for corporate America have been the major reasons for the negative sentiment on Wall Street (see Three Defensive ETFs for a Bear Market).
Also, a series of banking sector alarms like the Barclays LIBOR scandal, J.P. Morgan’s huge hedging loss and HSBC money laundering scandal have cause investors and businesses to take a conservative view, as they remain apprehensive of another financial crisis.
At a time like this when global risk aversion has taken its toll, it is prudent to think of an investment strategy which would increase the odds of a decent upside and also avoid some of the market’s biggest losers as of late.
One such way to do this in basket form is with momentum strategy ETFs. These funds take a host of stocks that have high momentum levels and invest in them, hopefully outperforming broad markets which include low momentum stocks in the process.
Not only do these ETFs also have significantly lower correlations with the broader markets, and could therefore also make for significant tools for diversification, but they could help avoid some stocks which could be poised to lead the way on the downside (see Three ETFs with Incredible Diversification).
However, investors should note that one of the major drawbacks of momentum ETFs is its liquidity. The dangerously low average daily volume for the funds targeting this space might prove to be a bottleneck for many investors adding to total costs.
Still, for those investors willing to capitalize on the promise of the technique in these uncertain markets, an ETF approach could be the way to go. For these investors, we have highlighted a few of the top funds in this segment, each of which possess their own pros and cons as well as unique ways in targeting the market:
The Russell 1000 High Momentum ETF (HMTM) and the Russell 2000 High Momentum ETF (SHMO) were both launched during May of 2011 by the Russell fund family in an attempt to gain a competitive advantage in the High Momentum ETF space. HMTH targets high momentum on large cap stocks and while SHMO targets the same thing in the small cap space.
The investment strategy and index methodology of both the ETFs is very similar. HMTM tracks the Russell Axioma U.S. Large Cap High Momentum Index which is a subset of the Russell 1000 Index whereas SHMO tracks the Russell-Axioma U.S. Small Cap High Momentum Index which is a subset of the Russell 2000 Index.
To construct the underlying index, both funds start with the parent index and choose stocks which exhibit momentum characteristics. This is measured as the cumulative returns of a particular stock for the previous 250 trading days, barring the last 20 trading periods.
In order to minimize higher portfolio turnover and transaction costs, HMTM and SHMO limit their exposure to 200 and 400 high momentum stocks respectively from the appropriate category of their entire universe of stocks (see more in the Zacks ETF Center).
Also, their portfolios are reviewed and rebalanced on a monthly basis to focus on the current trends pertaining to high momentum stocks. HMTH charges a paltry expense ratio of 20 basis points and the expense ratio for SHMO stands at 0.30%.
However, both of these funds have failed to draw the attention of investors, as indicated by the poor inflow into their asset base and average daily volumes.
HMTM has an AUM of $5.21 million and an average daily volume of just 2,876 shares. On the other hand, SHMO has managed to amass nearly $5.04 million in assets under management and around 1,094 of its shares exchange hands each day.
However these two ETF types have very little correlation with the S&P 500, as indicated by R-Squared values of 25.40% for HMTM and 15.84% for SHMO on a one year basis as of 30th June 2012 (read The Trend Is Your Friend with These Three ETFs).
From a performance perspective, both ETFs have managed to report positive double digit returns this year, as calculated on 30th June 2012. HMTM is up by 11.63%, whereas SHMO has managed to gain 10.63%.
The Russell Developed ex-U.S. High Momentum ETF (XHMO) is another offering by the Russell fund family which targets the high momentum stocks from the international equity space. The ETF captures the essence of developed market equities showing high momentum characteristics. The index methodology for this product is the same as HMTM and SHMO.
The fund tracks the Russell-Axioma Developed ex-U.S. Large Cap High Momentum Index which is a subset of the Russell Developed ex-U.S. Large Cap Index. Launched in November of 2011, it is the youngest of the three high momentum ETFs by the Russell fund family.
XHMO also provides opportunities for international diversification. Having said this, it is prudent to note that the ETF will be subject to currency risk as it gives investors an international flavor (read Three Currency ETFs Outperforming the Dollar). Moreover, it seeks exposure only to the developed market equities which are significantly less volatile than their emerging market counterparts.
From a country exposure perspective, the assets of the ETF are extremely concentrated in the top three nations, which account for over 50% of its total assets. These include the United Kingdom (24.80%), Japan (16.23%) and Canada (10.90%). Apart from these, the ETF places its bets on other developed countries such as France, Switzerland, Australia, and Hong Kong (see Comprehensive Guide to Total Market ETFs).
Due to its high exposure to the troubled European continent, the ETF lags behind in terms of year-to-date total returns. As of 30th June 2012, XHMO is up only by 3.33%.
Also, an average daily volume of just 2,274 shares and total assets of $4.99 million might be cause for concern for investors. However, the ETF is relatively inexpensive, sporting 25 basis points in fees and expenses.
Launched in August of 2007, the ELEMENTS SPECTRUM Large Cap U.S. Sector ETN (EEH) is perhaps the oldest in the high momentum exchange traded product space. Despite this, the ETN lags behind its three exchange traded peers in its group, and discussed above, in terms of total assets and average daily volume. It has total assets of $1.41 million and an average daily volume of just 1,091 shares.
The ETN tracks the SPECTRUM Large Cap U.S. Sector Momentum Index which consists of the ten sub indexes of the S&P 500 Total Return Index. EEH weighs its components on the basis of their performance, relative to the S&P 500 Total Return Index.
The sub indexes which outperform the S&P 500 Total Return Index are assigned higher weightings and the ones which underperform are assigned lower weightings (read Alternative ETF Weighting Methodologies 101).
However intriguing the strategy may sound, it appears to have failed to achieve its objective as of late. The ETN has returned 2.80% this year compared to the S&P 500 Total return index which has returned 11.01% at the year’s half way point
Also, of all the exchange traded products in the high momentum space, the expense ratio for EEH is the highest, at a whopping 75 basis points.
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