MTUM And PDP: Momentum ETFs And Their Underlying Indexes

Seeking Alpha Publication

Summary

Momentum Strategy works well in a bullish market.

There are a handful Momentum ETFs for investors to use as investment vehicles.

Understanding the underlying index strategies help investors make the right choice.

MTUM is preferential because of its large AuM, low expense ratio, transparent methodology and sound track record.

Momentum, by name, means the tendency to keep the original status. In the realm of the stock market, if the stock price is up today, and if the momentum carries on, you can predict an even higher performance the next day, and vice versa.

Momentum ETFs ought to be wisely used by investors contingent on different regimes. Under some extreme circumstances such as the financial crisis in 2008, all stocks clustered and plunged, betting on any momentum strategies is equivalent to an investment suicide. On the other hand, in this nascent Donald Trump era, the market has displayed somewhat up-trending momentum. NASDAQ, SP500 are hitting record highs, and more investors are pouring in money to ride the wave.

There are a handful of momentum ETFs: the iShares Edge MSCI USA Momentum Factor ETF (NYSEARCA:MTUM), PowerShares DWA Momentum Portfolio ETF (NASDAQ:PDP), SPDR Russell 1000 Momentum Focus ETF (NYSEARCA:ONEO), PowerShares DWA Emerging Markets Momentum Portfolio ETF (NASDAQ:PIE) … available in the market, providing handy tools for the investors. The AuM of the above five ETFs is $2,101.7 Million, $1425.3 Million, $451.7 Million, $183.7 Million and $147.5 Million respectively.

Let’s explore MTUM and PDP, the two largest funds’ underlying indexes to understand and hence, be able to choose the most suitable Momentum ETF.

The iShares Edge MSCI USA Momentum Factor ETF, MTUM, was launched in April 2013, with $2.83 billion assets already tied to it in June 2017, is benchmarked against the MSCI USA Momentum Index.

This index starts from an applicable universe including all the existing constituents of an underlying MSCI Parent Index. A Momentum value for each security is calculated by combining recent 12-month and 6-month local price performance of the security. The prices are adjusted by risk and then normalized by the standard deviation to derive a Z score.

Risk-adjusted Price Momentum = Price Momentum / σi

Where σi = Annualized Standard Deviation of weekly local price returns over the period of 3 years.

Z = 6-month Momentum Z-score*0.5 + 12-month Momentum Z-score*0.5

The Momentum Z-score is winsorized at three times threshold, i.e. the Z-scores above three are capped at three and Z-scores below -3 are capped at -3.

Then all component stocks are ranked in a descending order based on their Z scores. The index has a fixed number of constituents, so the stock will be cut out when it hits beyond the lowest rank. (Referenced Link)

The MSCI Momentum Indexes are rebalanced on a semi-annual basis, a natural question here is why they are only rebalanced semi-annually; won’t the momentum dissipate given such a long time horizon? It is quite arguably as one can say that momentum needs an ample time to carry out, therefore, a less frequent rebalancing schedule may be more appropriate.

The PowerShares DWA Momentum Portfolio, PDP, started in March 2007 with $1.4 billion AuM in June 2017, is tagged to Dorsey Wright Technical Leaders Index (DWTL). As to the methodology of DWTL, the very first step, setting the initial universe, it is the NASDAQ US Benchmark index (NQUSB), then they are ranked by market capitalization to select the top 1000. A minimum three-month average daily dollar trading volume of $1 million is required, the security must be classified as either a common stock or shares of beneficial interest of REIT. All securities in each Index universe are further ranked using a proprietary relative strength (momentum) measure. Each security’s score is based on intermediate and long-term price movements relative to a representative market benchmark. The Indexes are rebalanced and reconstituted at the end of each calendar quarter. A minimum of 30 securities is selected for each Index. The Index weights are determined by the scores of each security in their respective Index. Securities with higher scores receive larger weights in the Index.

The calculation of the relative strength (momentum) score is pursuant to Dorsey, Wright & Associates, and LLC’s proprietary methodology. Public documents seem unavailable. However, the methodology is very likely similar to MSCI’s momentum index described above. (Referenced Link)

Next, we compare the performance and holdings between these two ETFs using Nasdaq Composite as a benchmark.

Both funds are highly correlated to the market, represented by Nasdaq Composite in the below two charts, however, they also under- performed.

MTUM came to market much later than PDP (2013 vs. 2007), but has since double the AuM of PDP. The reasons, very likely, are two: firstly, the high expense ratio 0.64% of PDP put a damp on investors comparing it to the 0.15% offered by BlackRock’s MTUM; secondly, MTUM’s a clear, transparent strategy compared to the black-box, proprietary mechanism claimed by PDP.

Take a deep look into their holdings, MTUM has 120, while PDP contains 100 constituents, the funds hold only 22 companies in common, which is only about a 20% overlapping rate. And the discrepancy between the two is a clear indication to investors that even both names indicate that they are “momentum” funds, their construction is vastly different.

Below is a performance comparison. You can see that MTUM outperformed PDP within the same comparable time period. In conjunction with the two reasons I described above – MTUM’s expense ratio is only a quarter that of PDP’s and MTUM’s methodology to compute momentum score is much more transparent than that of PDP, I highly recommend MTUM for investors who want to ride the momentum wave.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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