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By Samuel Lee

Momentum is the tendency for performance to persist. Barring perhaps Treasury bonds and Japanese stocks, momentum has been found in nearly every market and asset class studied. Its prevalence is the most convincing refutation of the efficient-markets hypothesis. In partnership with the Arizona State Retirement System, iShares earlier this year launched the iShares MSCI USA Momentum Factor (MTUM), another sign that momentum strategies are becoming more common and commodified.

The fund is promising. It charges a slender 0.15% expense ratio. Its secondary market liquidity is decent, no doubt helped by ASRS' $100 million seed contribution to the fund. Most important, its exchange-traded fund wrapper and its sensible index construction methodology put to rest the biggest objection to momentum strategies: They cost too much in taxes, transaction costs, and management fees. MTUM's ETF structure mitigates some of the tax bite. And by dealing in today's highly liquid large- and mid-cap stocks, its frictional costs won't likely amount to much.

Why It Works
There are lots of stories out there that seek to explain why momentum exists, but the most convincing appeal to behavioral biases. The brain is a wonderful machine, but it uses a lot of shortcuts or heuristics. In markets, these shortcuts can lead us to biased decisions. For one, we're slow to adjust to new information, "anchoring" our adjustments to old values. And we prefer to sell winners to lock in gains and hold on to losers with the hope of eventually breaking even, a bias called the "disposition effect." The combination of the two prevents stock prices from quickly adjusting to new information, leading to performance persistence.

More powerfully, when we observe price trends, we extrapolate them into the future, and when we see others riding the wave, we're tempted to join in. The bandwagon effect can send prices to extremes. Obviously, markets don't stay crazy forever. At some point, the fundamentals kick in, and momentum-driven movements suddenly reverse.

So, if you sell to lock in gains, don't want to sell losers because you're waiting to break even, get caught up in crowd psychology, or allow irrelevant information to affect your estimates of an asset's fair value--congratulations, you help make momentum possible!

There's no shame in it. Momentum doesn't originate from mania but begins with skepticism. Consider Apple (AAPL). As Apple kept posting blockbuster results, sober analysts consistently underreacted to the evidence that Apple's growth trajectory was steeper than they expected. Apple always looked expensive--until it didn't. By 2012, after years of being wrong, many skeptics capitulated. Some became true believers. It's around this time that the slowpokes began showing up droves to throw fistfuls of cash at Apple stock, and the bandwagon effect took hold. Then, as manias are wont to do, it imploded.

When there is stupidity, there's a profit opportunity. I admit there's something unsavory about the way momentum strategies go about it. By purposefully investing with the crowd, the momentum investor often helps push prices away from fair value and profits by selling to the greater fool. The strategy is a favorite of stock brokers because they love the commission income from churning their clients’ accounts. Despite my misgivings, the evidence for the strategy's efficacy is so overwhelming it makes sense to apply it to one's portfolio provided one can do so cheaply. MTUM offers such an avenue.

How It Works
MTUM tracks the MSCI USA Momentum Index, which applies a twist to the traditional momentum strategy. In most academic studies, momentum is measured by 12-month trailing price return, excluding the most recent month, for 11 months of price return. The most recent month is excluded because stocks exhibit short-term mean reversion: The best-performing stocks in the past month often underperform the subsequent month.

The MSCI version for each stock measures six- and 12-month price momentum, excluding the most recent month. However, unlike the academic studies, the six- and 12-month windows are just moved back a month: The six-month signal is calculated by using months two to seven, the 12-month signal uses months two to 13. The returns are divided by the annualized standard deviation of the stock's trailing three-year returns. Then they're converted to z-scores, a standard method for normalizing data into a "bell curve" distribution. The z-scores of the six-and 12-month signals are averaged to produce a final momentum score, which is multiplied by the stock's market cap to come up with a final weight.

The overall effect of looking at risk-adjusted return and averaging two signals is to ensure the consistency of returns. Research has indicated that stocks that smoothly rise or fall are more likely to exhibit momentum than stocks that suddenly rise or collapse.

Typical of MSCI, the index is rebalanced twice a year, which keeps turnover down but weakens the fund's momentum tilt. Intriguingly, the index has a conditional rule that checks each month to see whether the current month's volatility has steeply risen versus the past month's volatility. If the condition is met, the index rebalances but only using the six-month signal.

This rule was implemented to protect against momentum crashes. During bear markets, momentum strategies switch to defensive stocks and miss out on the subsequent recoveries led by cyclical stocks. The two worst periods for momentum in the United States occurred during the Great Depression and the 2008 financial crisis.

The back-tested returns look good. From the index's hypothetical start in May 1994 to the end of April 2013, it beat the MSCI USA Index by 3.45 percentage points annualized. This is too good to be true. I highly doubt the strategy will produce such excellent results in the future. However, given the weight of the evidence, I think the odds favor MTUM earning some momentum premium in the future. Even if it's nil, the fund is so cheap it's unlikely to hurt you much.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

This article was published in the May 2013 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor here.

Source: MTUM: Profiting From The Madness Of Crowds