Lawrence Hamtil from Fortune Financial Advisors had a brief research paper from February that I just stumbled across that looks at blending momentum and low volatility in a portfolio. The catalyst was this longer paper from S&P Dow Jones Indices as well as an apparent curiosity of what would happen blending factors that are at "opposite ends of the spectrum."
We don't talk a lot about factors here as I believe the concept adds an unnecessary layer of complication to understanding markets, building a portfolio, and then managing that portfolio. It's not that I am anti-factor or smart beta for that matter, but regardless of what a fund's name is, you still need to look through to the holdings and really understand what the fund holds so that it can be evaluated for risk factors. We'll look at an example of that below.
Lawrence provides quite a few charts as well as some return data.
What appears to be playing out is a similar effect as when you blend foreign and domestic equities together, but the hope with Hamtil's idea is that when the US equity market (market cap weighted) is headed higher, momentum should be outperforming market cap weighted and when the equity market is headed lower, low volatility should be outperforming market cap weighting. Lawrence provides charts to support the contention. Draw your own conclusion but I wanted to look at how to implement this idea because even if this idea does not resonate with you, some other idea might and hopefully, this can help with figuring how to compare funds that appear to do similar things.
There aren't actually a lot of broad-based, large-cap momentum funds that maintain equity exposure. There are one or two that will take defensive action, but I did not want to consider those immediately only because Hamtil's study didn't include that overlay.
Here are four momentum funds compared to the SPDR S&P 500 (NYSEARCA:SPY) for five years (not all the funds are that old):
That the momentum funds generally outperformed SPY in an up market should not be a surprise. There is no guarantee this will happen in the future, but it is not a surprise.
Looking a little closer:
iShares Edge MSCI USA Momentum Factor ETF (BATS:MTUM): "stocks selected and weighted based on price appreciation over 6- and 12-month periods and low volatility over the past 3 years." It has been the best performer, has the most assets but is actually a multifactor fund with momentum and low volatility.
Invesco DWA Momentum ETF (NASDAQ:PDP): this fund is relatively expensive, but it looks much different in terms of sector weightings and what it owns versus the other funds.
Alpha Architect U.S. Quantitative Momentum ETF (BATS:QMOM): "it targets the 10% of stocks with the highest total return over the last 12 months, excluding the most recent month. The fund also screens for consistency of momentum by excluding stocks with too many negative-return days during the 12-month period." It is relatively expensive and it equal weights the holdings which I have to wonder whether that dilutes the momentum somewhat. They have a system, one stock scores the highest and one in the fund scores the lowest. Maybe the lowest scoring stock should be there but do you want it to have the same weight as the highest scoring stock?
SPDR S&P 1500 Momentum Tilt ETF (NYSEARCA:MMTM): this is the cheapest fund, but it includes market cap weighting in its process which results in the fund currently having 32% in technology. That doesn't have to be a negative depending on how much tech is in the low volatility fund that MMTM might be paired with.
There are fewer low volatility funds that I would consider here, with the market having done so well for so many years maybe the demand for the potential protection offered by low vol has diminished. Not surprisingly, the low volatility funds have lagged the S&P 500 as the market has gone higher.
The Invesco S&P 500 Low Volatility ETF (NYSE:SPLV) might be the first low volatility ETF, but it has one flaw that leads me to want to stay away which is that it is very heavy in utilities which makes it more vulnerable to interest rate risk than the three funds charted.
SPDR SSGA US Large-Cap Low Volatility Index (NYSEARCA:LGLV): It is very inexpensive but has obviously lagged FDLO badly. It considers a universe of 1500 names to choose from which results in the fund looking much different than the S&P 500 in terms of sector weightings and individual holdings. It has 32% in financials and just 16% in tech which might make for a good pairing with MMTM in terms of avoiding too much tech exposure.
Fidelity Low Volatility Factor ETF (NYSEARCA:FDLO): The fund is not that cheap, it includes low volatility of both price and earnings and at the sector level looks fairly similar to the S&P 500.
iShares Edge MSCI Minimum Volatility USA ETF (BATS:USMV): The fund is cheap, it is huge and in addition to low volatility, it considers correlation in its process for constructing the portfolio. The fund looks a little different than the S&P 500 at the sector level, it avoids interest rate risk better than SPLV but is a little heavy in healthcare.
While Hamtil was able to study the strategies (momentum and low volatility), these funds didn't exist during the last bear market. Even if the low volatility funds did and they did spectacularly well, there's no guarantee that they would do well in the next bear markets. The momentum funds generally have done well since their respective inceptions.
In trying to select funds to pair together, I would pay attention to sector weightings. The future make ups of funds are not knowable, but where tech is a risk factor these days for its 26% weighting in the S&P 500, owning MTUM (which has 38% in tech) and FDLO (which has 24% in tech) with a 50/50 mix results in 31% in technology and interestingly, they own some of the same names in their respective top tens. Where the two funds are perhaps a substitute for just owning an S&P 500 fund, the overlap is not necessarily the end of the world even if it is not ideal.
Someone choosing this strategy, or any strategy, needs to be prepared to hold on and remain disciplined to it which means not throwing in the towel on the momentum fund the next time the market goes down a lot. Arguably, the moment when you'd want to throw in the towel is exactly when you should rebalance to buy more of the momentum fund. That is easy to say and realize that would be a good idea today while markets are still up a lot and emotions aren't heated but tougher to do when the S&P 500 is down 30% and you're bargaining with yourself about just trying to get back to even and that you'll never own another stock again.
If you wanted to start out with a slightly different strategy, the Aptus Behavioral Momentum Fund (BATS:BEMO) has a defensive component. It will switch to holding 7-10 year treasuries when the equity market as measured by a "broad-based U.S. equity market index" drops 10% (kind of like a stop loss) and then re-equitize when the "U.S. equity market (goes) above its moving average for a recent period." The quotes are from the prospectus, so it's vague. I have no idea whether anyone should own BEMO, but at a high level, it addresses a potential behavioral issue with Hamtil's portfolio, it is probably a fund you've never heard of and there are others that do similar things.
The point of this post was to learn about ETF portfolio construction, not to run out and buy the first fund listed in ETF.com's screener for the momentum and low volatility categories.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.