Andrew’s Angle

Momentum: If you can’t beat ‘em, join ‘em

Nov 17, 2020

The capacity of factor strategies appears large 

If you can’t beat ‘em, join ‘em.

This classic idiomatic expression epitomizes the momentum factor, a well-studied phenomenon in markets that has been a potent driver of excess returns. Momentum strategies identify and participate in trends, allocating to those securities that have been outperforming. Unlike well-known factors such as value and size, momentum is willing to go wherever the winners are, resulting in a dynamic approach that can keep up with quick changing trends.

One key potential benefit to investing in the momentum factor is that it tends to be negatively correlated to factors like size and value. This is because value looks for securities that are out of favor—often these stocks have declined in price, whereas momentum identifies securities that are trending upwards. Some of the most successful companies with positive trends become bigger and bigger, in contrast to a small size strategy that exits those companies when they become large. These negative correlations imply that there can be diversification benefits adding momentum strategies to small cap and value managers.

Chart: Correlations Matrix

Source: Morningstar Direct since 1/1/15 to 8/31/20. Excess return correlation over the first full month of common inception relative to the S&P 500 Index. Excess returns relative to the market are used to remove the effects of equity market beta.

The academic research backing the momentum factor is not new – Jegadeesh and Titman published a seminal paper on momentum in 19931 . At least two Nobel prize winners, Profs Robert Shiller and Richard Thaler, have contributed seminal research to the behavioral origins of the momentum factor—that investors tend to not immediately react to new information and exacerbate trends. More recently, the debate has shifted from “is momentum a factor?”, to “can momentum effectively be captured in the real world?” In this post, we dispel some commonly held myths about momentum and show that it can be captured – if you have the right wrapper.

Myth #1: Transaction costs/high turnover eat away any premium

Critics of momentum strategies typically point out that momentum is a high turnover strategy, and due to its higher turnover, transaction costs eat away any potential premium.

True, if you don’t implement it well. For example, The iShares MSCI USA Momentum Factor ETF (MTUM) typically has annual turnover between 100% to 150%.

MTUM - Annual Turnover

Chart: MTUM - Annual Turnover

Source: Morningstar Direct as of 12/31/19

Yet, the factor’s higher relative turnover has not affected the fund’s ability to capture momentum.

Hypothetical Growth of $100

Chart: Hypothetical Growth of $100

Source: Morningstar Direct as of common inception (4/16/13) to 8/31/20. The Hypothetical Growth of $100 chart reflects a hypothetical $100 investment and assumes reinvestment of dividends and capital gains. Fund expenses, including management fees and other expenses were deducted. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted, and numbers may reflect small variances due to rounding. Standardized performance and performance data current to the most recent month end may be found by clicking here. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Despite having higher turnover, MTUM still managed to outperform the market since its inception. In addition, the fund has also been able to closely track its benchmark (MSCI USA Momentum Index2) dispelling myths that an index-based ETF cannot efficiently track a high turnover index.

It should also be noted that MTUM uses the MSCI USA Index as it’s starting universe. This index is comprised of large and mid-cap US equities, which are generally highly liquid and cheaper to trade, further reducing the potential effects of transaction costs.

Myth #2: Consistent momentum factor exposure cannot be captured

Momentum is a fast-moving factor. Momentum naysayers have argued that investors are unable to have consistent exposure to the momentum factor in a passive index fund. They contend that market sentiment can change rapidly, and an index-based ETF with a pre-defined rebalance schedule cannot capture these swift changes in trends. To test this theory we analyzed the factor loadings of MTUM relative to the MSCI USA Index over the past five years, shown below. Factor loading scores combine several different measurements of momentum to determine if a portfolio owns positively-trending stocks. If the score is above 0, the portfolio has deeper momentum characteristics than the global average. If the score is below 0, the portfolio has below average exposure to trending stocks.

Momentum Exposure over Time

Chart: Momentum Exposure over Time

Source: FactSet. Exposures calculated using BARRA Global Equity Risk Model for Long-Term Investors (GEMLT) as of 8/31/20. Z-scores are standardized to have a mean of 0 and a standard deviation of 1. Z-scores are statistical measurements that show the number of standard deviations a portfolio’s exposure is away from the mean of the estimated universe.

The ETF has consistently shown positive momentum exposure, as well as higher exposure than the broad market. Even when markets sharply dropped in Q1 2020, and subsequently rebounded in the second quarter, MTUM was able to maintain positive momentum exposure throughout the change in market sentiment.

Myth #3: Momentum is a tax inefficient strategy

Given its relatively high turnover, some skeptics argue that momentum strategies are tax inefficient. And while it is true that higher turnover strategies can lead to higher realized taxable gains, MTUM has never paid out a capital gain since inception.

The ETF wrapper allows a higher turnover strategy, like momentum, to deliver its targeted exposure while protecting the fund from tax decay. Most trading of ETFs occurs on the secondary market – meaning when an investor sells their shares of an ETF, there is an investor on the opposite side who is buying those shares. In comparison, if an investor liquidates their shares of a mutual fund, the Portfolio Manager managing the mutual fund may need to sell underlying positions in the fund to raise cash. When the Portfolio Manager is forced to sell positions, the PM may realize taxable capital gains.

In addition, when an Authorized Participant redeems shares of an ETF, the underlying shares are delivered “in-kind.” The ETF does not have to sell securities in the open market, which otherwise could create a taxable event.

Due to the tax benefits of ETFs, MTUM has shown that momentum can be captured in a tax efficient manner.

Join ‘em

Momentum has a well-deserved place within a portfolio and is especially diversifying to traditional value and size strategies. An easy way to gain exposure to the momentum factor is to add a thoughtfully constructed, single factor momentum ETF—one that efficiently captures the momentum and that has historically exhibited tax efficiency.

As momentum has gained broader acceptance among academics as a factor, the narrative has shifted among practitioners as to whether momentum can effectively be captured. As MTUM has demonstrated, we believe that the answer is a resounding YES.

Andrew Ang
Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro and style ...
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