Momentum etf: Meaning, Criticisms & Real-World Uses

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What Is Momentum ETF?

A momentum ETF is an Exchange-Traded Fund designed to capitalize on the momentum effect, a phenomenon in Behavioral Finance where assets that have performed well in the recent past tend to continue to outperform, and assets that have performed poorly tend to continue to underperform. These ETFs fall under the broader category of Factor Investing, aiming to capture specific drivers of returns beyond traditional market beta. A momentum ETF typically invests in a portfolio of stocks exhibiting strong price trends over a defined look-back period. The underlying investment strategy of a momentum ETF is rooted in the idea that these trends have persistence.

History and Origin

The concept of momentum in financial markets has been observed for centuries, with evidence dating back to the 19th century in U.S. and U.K. equity data³⁹. However, modern academic research significantly solidified the momentum effect in 1993, when Narasimhan Jegadeesh and Sheridan Titman published their seminal paper, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency." Their work documented that strategies buying past winners and selling past losers generated significant profits over periods of three to twelve months³⁴, ³⁵, ³⁶, ³⁷, ³⁸.

Subsequently, in 1997, Mark Carhart incorporated a cross-sectional momentum factor into his four-factor model, extending the Fama-French three-factor model to better explain stock and mutual fund returns²⁹, ³⁰, ³¹, ³², ³³. The introduction of exchange-traded funds in 1993, with the first U.S.-listed ETF tracking the S&P 500, created a new vehicle for investors²⁴, ²⁵, ²⁶, ²⁷, ²⁸. The first factor-based ETF, including those focusing on momentum, emerged in the U.S. around 2000, allowing investors more direct access to strategies previously more challenging to implement for individual investors²³.

Key Takeaways

A momentum ETF seeks to profit from the tendency of past winning assets to continue their upward trend and past losing assets to continue their downward trend.
The underlying principle of a momentum ETF is based on the empirically observed momentum anomaly in financial markets.
These ETFs offer investors a way to gain exposure to a momentum Investment Strategy without needing to actively manage individual stock selections.
While historically profitable, momentum strategies, including those employed by a momentum ETF, are susceptible to sudden reversals or "crashes."
High portfolio turnover in a momentum ETF can lead to increased trading costs, potentially eroding returns.

Formula and Calculation

While there isn't a single universal formula for a momentum ETF, the core concept revolves around identifying assets with strong recent performance. A common approach involves calculating the "momentum score" for each asset. One widely used method, often associated with the Carhart four-factor model, calculates momentum (MOM or UMD, Up-Minus-Down) as the average return on high prior-return portfolios minus low prior-return portfolios²¹, ²².

The calculation for the momentum factor (MOM) in academic models is typically represented as:

$MOM = R_{winners} - R_{losers}$

Where:

(R_{winners}) = Average return of a portfolio of stocks with the highest past returns over a specified period.
(R_{losers}) = Average return of a portfolio of stocks with the lowest past returns over the same specified period.

The specific look-back period (e.g., 3-12 months, often excluding the most recent month to avoid short-term reversals) and the rebalancing frequency will vary depending on the particular momentum ETF's methodology¹⁹, ²⁰. This systematic approach is a key aspect of Quantitative Analysis in fund management.

Interpreting the Momentum ETF

Interpreting a momentum ETF involves understanding its underlying index or selection methodology and how it aims to capture the momentum premium. A momentum ETF's performance is driven by the relative strength of assets, meaning it seeks to identify stocks or other securities that have recently exhibited upward price trends and continue to hold them as long as the trend persists. Conversely, it will divest from or even short (in certain strategies) assets with negative momentum.

Investors should examine the specific criteria a momentum ETF uses to define "winners" and "losers," including the look-back period for performance, the ranking methodology, and the Rebalancing frequency. For example, a momentum ETF might track an index that selects the top 20% of stocks based on their past 12-month returns, excluding the most recent month. Understanding these nuances helps investors assess how closely the ETF aligns with their desired exposure to the momentum factor within their overall Asset Allocation.

Hypothetical Example

Consider an investor, Sarah, who believes in the persistence of price trends. She decides to invest in a hypothetical "Global Momentum ETF" that tracks an index of the top 20% of global equities based on their total returns over the past 11 months, rebalanced quarterly.

In Quarter 1, the ETF identifies several technology and renewable energy stocks as top performers based on their past 11-month returns. Sarah invests $10,000 in the ETF. As the quarter progresses, these selected stocks continue their upward trajectory, and the ETF's value increases.

At the end of Quarter 1, the ETF's index rebalances. The technology stocks still show strong momentum, but some renewable energy stocks have started to lag, while certain healthcare stocks have seen a surge in performance. The ETF's manager, following its predefined rules, sells some of the underperforming renewable energy stocks and buys into the new high-momentum healthcare stocks. This rebalancing allows Sarah's investment to continue seeking exposure to currently strong trends, demonstrating how a momentum ETF dynamically adjusts its holdings based on quantitative signals.

Practical Applications

Momentum ETFs are employed by investors seeking to integrate the momentum factor into their [Portfolio Management](https://diversification.com/term/portfolio-Adjusted Returns), aiming for potentially higher Risk-Adjusted Returns. These ETFs can be used to complement other investment styles, such as value or growth investing, to provide Diversification across different factor exposures. For instance, some investors might combine a momentum ETF with a value-oriented ETF, recognizing that these two factors can exhibit low correlation over time.

Additionally, a momentum ETF can be a tool for investors who believe in the behavioral biases that drive momentum, such as investor underreaction or overreaction to new information¹⁷, ¹⁸. By systematically investing in assets with strong recent performance, a momentum ETF attempts to profit from the delayed price adjustment that can occur in markets. While the concept of momentum challenges the strict form of the Market Efficiency hypothesis, its persistent empirical evidence has led to its widespread adoption in various investment products, including ETFs.

Limitations and Criticisms

Despite their historical outperformance, momentum ETFs and strategies face several limitations and criticisms. One significant drawback is their vulnerability to "momentum crashes," which are short but persistent periods of highly negative returns, often occurring during market reversals¹³, ¹⁴, ¹⁵, ¹⁶. These crashes can be particularly severe when the market shifts rapidly, as previously strong trends suddenly reverse, catching momentum strategies off guard¹¹, ¹². For example, momentum strategies experienced significant drawdowns after the dot-com bubble burst in 2000 and the 2008 financial crisis¹⁰.

Another criticism revolves around the high turnover inherent in many momentum strategies. Constantly buying past winners and selling past losers means frequent trading, which can lead to substantial transaction costs, including commissions and bid-ask spreads. These costs can significantly erode the returns of a momentum ETF, potentially negating some of the theoretical benefits⁸, ⁹. Research Affiliates, for instance, has noted that the price impact of trading costs associated with momentum strategies' high turnover can "obliterate the alpha"⁶, ⁷. Furthermore, some studies suggest that the effectiveness of momentum investing may have diminished in recent decades due to increased awareness and crowded trades⁵.

Momentum ETF vs. Mutual Fund

While both a momentum ETF and a Mutual Fund can offer exposure to momentum strategies, their structural differences create distinct advantages and disadvantages.

Feature	Momentum ETF	Momentum Mutual Fund
Trading	Traded on exchanges throughout the day like stocks; prices fluctuate based on supply and demand.	Bought and sold directly from the fund company at the end-of-day Net Asset Value (NAV).
Liquidity	Generally high, as shares can be bought and sold at any time during market hours.	Less liquid, as transactions occur only once per day.
Pricing	Market price can deviate from NAV, leading to premiums or discounts.	Always traded at NAV.
Fees & Expenses	Typically have lower Expense Ratios due to passive or semi-passive management and lower operational costs.	Can have higher expense ratios, particularly actively managed funds, which may include sales loads and higher management fees.
Transparency	Most are fully transparent, disclosing holdings daily.	Holdings typically disclosed less frequently (e.g., quarterly), though some actively managed ETFs are semi-transparent.
Tax Efficiency	Generally more tax-efficient due to in-kind creation/redemption mechanisms, which can reduce capital gains distributions.	Less tax-efficient, as portfolio turnover can trigger capital gains distributions that are passed on to shareholders.

The primary distinction lies in their trading mechanism and transparency. A momentum ETF offers intraday liquidity and often lower costs, appealing to investors who prefer the flexibility of stock trading. Conversely, a momentum mutual fund calculates its price once daily, which may be less appealing for tactical trading but could be suitable for long-term investors comfortable with less transparency in daily holdings.

FAQs

What is the "momentum effect" in investing?

The momentum effect refers to the empirical observation that assets that have performed well in the recent past (winners) tend to continue to perform well, and assets that have performed poorly (losers) tend to continue to perform poorly, over a medium-term horizon (e.g., 3 to 12 months)³, ⁴. This phenomenon is a key concept in Technical Analysis.

How does a momentum ETF select its holdings?

A momentum ETF typically employs a systematic, rule-based approach to select its holdings. This usually involves ranking a universe of assets (e.g., stocks) based on their past price performance over a specified period. The ETF then invests in a predetermined number or percentage of the highest-ranked assets. The portfolio is regularly rebalanced to maintain exposure to the strongest momentum trends².

Are momentum ETFs suitable for all investors?

Momentum ETFs may not be suitable for all investors. While they offer potential for higher returns, they also come with higher risks, including the possibility of sharp drawdowns during market reversals¹. Investors should consider their individual risk tolerance, investment horizon, and overall Asset Allocation before investing in a momentum ETF. They are generally considered more aggressive than broad market index funds.