The Momentum Factor – Do Momentum ETFs Deliver the Premium?

The Momentum factor is one of the most studied – and simultaneously perhaps the most misunderstood – elements in finance. Here we discuss the Momentum factor, how one might access it with so-called “momentum ETFs,” and whether or not investors can expect a premium.

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What Is the Momentum Factor?

A few years after the Fama French 3 Factor Model emerged, Mark Carhart introduced the addition of a factor called Momentum, written as MoM for monthly momentum.

The simple idea is that stocks that have been going up recently tend to keep going up for a short time, and stocks that have been going down recently tend to keep going down for a short period. A stock is considered to have positive momentum if its prior 12-month average of returns is positive.

Unfortunately, there are a few problems with the Momentum factor for long-term, buy-and-hold index investors.

First, chasing the Momentum factor invariably involves short-term market timing, either by the retail investor or, in the case of a momentum fund, the fund manager. Index investors by definition avoid – or should avoid – market timing, particularly over the short term, i.e. less than 12 months. This necessary short-term trading increases turnover from short-term buying and selling, adding greater tax liability and transaction costs, meaning it loses some points on the aforementioned “investable” criterion.

Secondly, the Momentum factor is constantly inversely correlated with the Value factor, as a Value stock by definition has just left a positive momentum phase. Thus, those investors betting on Value are inherently betting against Momentum, and vice versa. There is more robust evidence for the Value factor; I personally choose to tilt Value.

Lastly, recall the “intuitive” criterion that factors must have a logical explanation. There’s no logical explanation for the Momentum factor. Momentum appears to be behavioral in nature due to herding based on news like earnings announcements, unlike the purely risk-based factors like Size and Value.

Separate from the factor premium (cross-sectional momentum), day traders use an individual stock’s momentum per se as a technical indicator (time series momentum) in a momentum-based trading strategy.

Momentum Funds – Do They Capture the Premium?

Identifying factors is one thing. Implementing them in a real world portfolio is another challenge altogether. In a nutshell, the Momentum factor is hard to capture and profit from in the real world after fees and the aforementioned trading costs and high turnover necessary to chase the factor.

The Momentum premium decays quickly. Dimensional found that “10–12 months after classification as high momentum, the excess return of upward momentum stocks was no longer positive on average.” They also looked at U.S. funds claiming to target Momentum and concluded that “the vast majority were unable to convert favorable premium performance into higher-than-market returns, after fees and expenses.”

Basically, the Momentum factor premium can be simulated just fine in the lab, but can’t be captured – at least so far – in a live fund in a cost-efficient way that delivers excess return to the investor.

Funds that attempt to capture Momentum include MTUM, PDP, QMOM, and IMOM. The performance of some of these funds can largely be attributed not to their capturing the Momentum factor, but simply to their exposure to market beta and large cap growth stocks, which have had a stellar run over the last decade. We can see this in the fact that the returns of these funds are not correlated with the actual Momentum factor. Moreover, long-short strategies that would provide the truest loading on Momentum are not available in the retail space.

So should we simply ignore Momentum? Probably not. Both Dimensional and Avantis consider Momentum at the time of their trades to make sure they're not betting against the factor. I'm satisfied with my exposure to it through that process.

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