"Momentum ETFs: The devil is in the change of favorites"

ETFs have taught fund managers to fear. But because ETF providers are also chasing the outperformance myth, they are also trying to outsmart Mr. Market with factor ETFs. The momentum factor is considered to be successful in the long term. Momentum ETFs are a good example of how ETFs can sometimes be too active, as Ali Masarwah, Managing Director of financial services provider envestor, shows.

26 February?2024 FRANKFURT (envestor). The asset management industry is driven by storytelling. This doesn't have to be a bad thing per se, as many people find the stock market rather dull, which is why exciting stories can pave the way to investment happiness.

Probably the most common myth about actively managed funds is the promise of fabulous returns. Fund managers are able to outperform their benchmark indices by skillfully exploiting their information advantage. This is true in individual cases and also in certain fund categories, but not on the whole. In the long term, at best around a fifth of all active funds manage to outperform an adequate benchmark. The reason: too high costs and too much tactical back and forth.

And so it is no wonder that ETFs have made a remarkable triumphant advance in recent years. Around 20 percent of all fund assets across Europe are invested in index funds. ETFs benefit from the two disadvantages mentioned above. All ETFs? No, because ETF providers - just like fund managers - fall into the trap of the outperformance narrative. However, they cannot refer to management exploits, but to "evidence-based" studies.

Financial science has been working for decades to track down the components of market returns. One pioneering development was the three-factor model by Eugene Fama and Kenneth French. They identified the principle of alternative sources of return in 1992. In addition to the general market return, they identified the so-called value and size effects, which systematically delivered different (or superior) returns than the market. The momentum factor was added to the model by Mark Carhart in 1997.

Momentum strategies are considered to be particularly successful. They rely on the price momentum of past winners. This contradicts the popular efficient market hypothesis, according to which all information is already contained in the prices.

Seen in this light, the momentum factor is a nightmare for efficiency market fans: Mr. Market can be outperformed with the simple method of "betting on past winners". The index provider MSCI calculates that the MSCI World Momentum has gained 10.9 percent per year over the past 30 years, while the MSCI World has only managed a gain of 8.1 percent p.a. (as at the end of January 2024, calculated in US dollars). Apparently, the human tendency to follow the swarm is not entirely wrong in the long term after all.

So put everything in a momentum ETF and you're done? There is - of course - a catch: in the short term, things can look very different. Over the past three years, the MSCI World has outperformed its momentum counterpart: up 8.6 percent p.a. compared to just 3.8 percent for the MSCI World Momentum. Even over the five-year period, the Momentum Index lags slightly behind the benchmark. This may not be a problem for long-term investors, but it does mean that they are adopting the arguments of active fund management: "come back!".

If you take a more inquisitive approach, you will see that the success and failure of momentum approaches in recent years has mainly been down to tech stocks. Their performance has been quite erratic since 2018, and since momentum approaches are slow to "switch" to past winners, the very thing that causes momentum strategies to stumble happened: sideways markets slowed them down. The motto then applies: back and forth empties the pocket.

The chart below says more than 1,000 words: It shows the weighting of tech stocks in an ETF on the MSCI World compared to their weighting in an ETF on the MSCI World Momentum since the beginning of 2021. The coronavirus correction was only delayed for the momentum ETF in 2021. After the start of the growth correction in fall 2021, the ETF only turned the tide in May 2022 and reduced the tech allocation from over 30% to below 10%.

After the Magnificent 7 was also caught up in the tech correction in the second half of 2021, the Momentum ETF lowered its tech allocation again in November to just 4%. It was not until May 2023 that the Momentum ETF increased the tech share to over 20% - the tech share in the MSCI World had already risen noticeably in January 2023, as the recovery had already begun in December 2022. It was not until November 2023 that the Momentum ETF lost speed again and ended up with a significant overweight in tech stocks, which it has been steadily increasing ever since, currently at just under 33% compared to 24.5% in the MSCI World.

In recent years, the MSCI World Momentum has behaved like a stubborn active manager who initially sticks to his guns, only to grumble and reluctantly give in and jump on the bandwagon.If the trend consolidates and Nvidia and Co. remain "on top", momentum strategies will be the big winners in 2024. However, another trend reversal is also conceivable - just think what would happen to growth stocks if the central banks do not cut interest rates as much as the augurs expect this year.

Those who follow the momentum approach should nevertheless bear in mind that trend changes in momentum strategies can also have an impact on performance in the medium term.Anyone who goes against Mr. Market can also look old for a long time. Even ETFs.

By: Ali Masarwah Masarwah, February 26, 2024, ? envestor.de