MARKET INSIGHTS

How momentum investing can help capture trends

Aug 25, 2020
  • BlackRock

Key takeaways:

  • The pandemic has created winners and losers in the U.S. stock market
  • The momentum factor captures stocks with upward price trends, and momentum factor ETFs seek to provide exposure to momentum stocks.
  • The iShares MSCI USA Momentum Factor Index ETF (XMTM) can help investors capture certain changes in the market, as represented by equities with upward price momentum as well as emerging investment themes that often cut across sectors

Abrupt shifts in consumer behavior in 2020 are giving rise to new winners in the U.S. stock market.

The COVID-19 pandemic has cast a spotlight on health care stocks, for example, and stoked fresh demand for the companies best positioned to feed, entertain and connect a global population getting used to spending time at home.

Investors should note that changes in market trends are reflected in the compositional changes in momentum indexes over time, which can capture the market’s views on what’s in favor. Right now, ETFs that seek to track momentum indexes contain stocks that the market believes will benefit from the “new normal.”

Momentum in action

Buying recent winners is known in the factor investing world as investing in momentum. Research supporting momentum investing can sound a lot like Isaac Newton’s first law, which states that objects in motion will stay in motion until acted upon by external forces. The idea is that strong performance causes investors to pile-on, thereby reinforcing the price trend for a while longer. Momentum can be thought of as the market’s view on “what’s working now.”

Big changes afoot

XMTM’s index, the MSCI USA Momentum Index, uses a rules-based approach to target stocks with the highest risk-adjusted returns over the recent history. This bottoms-up approach allows the index to select securities that may be a more accurate reflection of “what’s working” than traditional sectors.

Look no further than health care. Profound changes to the MSCI USA Momentum Index mirror the rapid evolution of market expectations in a COVID-19 world, which has increased focused on health care stocks.

Stocks in the health care sector now represent over 31% of the portfolio’s weighting, up from around 11% at the end of 2019.1 But specifically, pharmaceutical and biotechnology companies working on a coronavirus vaccine and related therapies have seen a particular increase, and health care products have been nearly eliminated. Technology, communication services and consumer discretionary stocks have also seen their weightings increase.

On the flip side, utilities and real estate, which had represented significant overweight positions headed into this year, have fallen out of the index as worries about slower economic growth weigh down those segments. Retail exposure in the momentum index has fallen sharply as brick-and-mortar stores sit idle and shoppers look online.

MSCI USA Momentum Index Sector Weights (%)

MSCI USA Momentum Index Sector Weights (%)

Source: Factset (as of August 6, 2020). Asset allocation and sector exposure subject to change.

Health Care

Health Care

Source: Factset (as of August 6, 2020). Asset allocation and sector exposure subject to change.

Consumer Discretionary

Consumer Discretionary

Source: Factset (as of August 6, 2020). Asset allocation and sector exposure subject to change.

This effort to find “what’s working” is not unique to the COVID-19 pandemic because the MSCI USA Momentum Index frequently changes its holdings. Annual turnover has exceeded 100% for every calendar year since inception. Regardless of the investing environment, this strategy allows investors to gain exposure to stocks and sectors that are trending.

MSCI USA Momentum Index - Annual Turnover

MSCI USA Momentum Index - Annual Turnover

Source: Morningstar (as of July 27, 2020). Asset allocation and sector exposure subject to change.

Momentum ETFs offer access to fast-changing market trends

Momentum strategies can help investors capture changes in market trends as well as emerging investment themes like “working from home” because they reach across sectors in ways that more narrowly focused strategies, such as single sector investing, cannot. Put another way, in limiting themselves to one sector, investors may miss advancements and trends that cut across sectors or only affect subsectors.

The MSCI USA Momentum Index is designed to rebalance semiannually to ensure that its holdings reflect recently highflying stocks, and this year underscores how quickly market leadership can change.

Holly Framsted, CFA
U.S. Head of Factor ETFs
Contributor: Jim Fuson