JMOM - JMOM: High-Quality Low-Cost ETF With Valuation Being A Perpetual Concern

Summary

• JMOM is based on the JP Morgan US Momentum Factor Index, with constituents selected from the Russell 1000.
• Skeptics would likely point to its valuation issue, which is partly a consequence of the fund being overweight in mega and large caps.
• Optimists would note that its past performance has been comparatively robust and its currently large exposure to high-quality stocks bodes well for returns going forward.
• Nevertheless, in my view, the current environment is not supportive of momentum-centered portfolios, even those with a meaningful footprint in quality stocks as valuation is not a factor to ignore.

Taking a short break from covering dividend- and value-focused (and value-ish) funds, today I would like to take a closer look at the JPMorgan U.S. Momentum Factor ETF (JMOM), a fund incepted in November 2017, with assets under management now standing at around $239 million.

I should acknowledge that the momentum factor is a powerful one, capable of delivering outstanding returns when stars align. One such period was in 2020 when markets were euphoric, disregarding the fundamentals and pushing multiples to levels hardly seen before. Nevertheless, I am not a proponent of such strategies, especially when markets are jittery and inflation is confidently delivering surprises to overly enthusiastic bulls.

So although JMOM is a nice representative of this class, with wafer-thin fees at just 12 bps , relatively strong past performance, and top-quality holdings, it is also not short of downsides, with valuation being the central one, thus a Buy rating is unjustified at this point.

What is JMOM's investment strategy?

According to its website , JMOM is based on the JP Morgan US Momentum Factor Index, which is rebalanced quarterly. The selection universe is the Russell 1000, a barometer of U.S. large- and mid-cap echelons. From that universe, stocks with the strongest twelve-month risk-adjusted returns are picked for the momentum index.

One of the principles the index follows is sector neutrality, which means JMOM's mix should not deviate much from the one of the iShares Russell 1000 ETF ( IWB ), which in practice implies an overweening exposure to technology (in the Industry Classification Benchmark system) for the foreseeable future, unless U.S. tech juggernauts experience a catastrophic valuation reset, the possibility of which, in my opinion, is teetering somewhere close to zero.

What bears say

The obvious disadvantage of almost all momentum portfolios is their inevitable expensiveness. Investors might assume that this is not the case during rare capital rotations back to value. As value stocks trounce their growth peers, they have all the prerequisites to expand their presence in the momentum-chasing portfolios. Nevertheless, despite the fact that in 2022, value stocks were in the limelight (and they still have solid potential in spite of the inflation worries), JMOM and similar funds are still overweight in stocks priced at a premium.

More specifically, as of March 2, there were 285 holdings in the JMOM portfolio, with the weighted-average market capitalization standing at $199.4 billion, as per my estimates. Technology is the largest allocation (26.4%) followed by consumer discretionary (14.1%).

What can the earnings yield tell us? With the figure at 5.4%, it seems that this portfolio is trading at a discount to the S&P 500 index which is currently offering a yield of around 5% . However, focusing only on the EY would certainly be myopic. There is a bigger story told by the Quant Valuation grade, and not the story I would like.

More specifically, just 13.6% of the holdings have a B- Quant Valuation grade or better, while about 64% are clearly overvalued, with a D+ rating or worse. I should note here that this is not entirely the consequence of the portfolio being overweight mega-caps, even though there is a meaningful amount of mega-caps (over 36% of the net assets); there are overvalued mid caps as well, like Eagle Materials ( EXP ), a $5.3 billion construction materials company with a 0.24% weight in the fund's portfolio.

So the major argument that bears might present here is that lofty multiples - that most momentum ETF holdings are trading with - present meaningful risk in the current uncertain environment, excessive valuations can become more realistic in the blink of an eye if the expectations for the cost of capital shoot higher with yet another inflation surprise.

What bulls say

Decent performance delivered since inception, with nuances

Even though there is a lot to dislike about momentum strategies, especially during downturns, JMOM does have a few critical advantages.

First and foremost, the major argument bulls can present here is that JMOM can be justly proud of its performance since its inception in November 2017 as it outperformed a few peers leveraging similar strategies like the iShares MSCI USA Momentum Factor ETF ( MTUM ) and Invesco DWA Momentum ETF ( PDP ); regarding MTUM, I discussed its advantages and vulnerabilities in the April 2022 article . This point is supported by the data below; the period covered is December 2017 - February 2023.

Created by the author using data from Portfolio Visualizer

What is the flipside? The market represented by the iShares Core S&P 500 ETF ( IVV ) still did better over that period, with lower volatility and higher risk-adjusted returns (as illustrated by the Sharpe and Sortino ratios). JMOM finished ahead of this ETF only in 2017 and 2020 as can be seen below.

Also, SPMO managed to deliver a marginally higher compound annual growth rate of 10.3%, again with a lower standard deviation.

The size factor bolsters quality

With the selection universe for its underlying index being the Russell 1000 index, JMOM should also have adequate quality as large caps are naturally more profitable and more resilient than their smaller counterparts. That being said, my dear readers who are well-versed in index methodologies might note here that this Russell benchmark does not require positive net earnings to be delivered to become eligible for inclusion, in contrast to the S&P 500, which might adversely affect quality. I should concur here, though with a caveat that I regard the risk of unprofitable companies with characteristics of classic value traps percolating into the JMOM basket and influencing its returns significantly as diminutive.

In the current version, JMOM's portfolio has profitability characteristics close to excellent, with only 1% of the net assets allocated to companies with sector-lagging margins and returns on capital (a D+ Quant Profitability grade and worse). One example is Wolfspeed ( WOLF ), a semiconductor player focused on silicon carbide and gallium nitride materials, which for now is struggling to deliver the TTM earnings before interest and tax, let alone net income. At the same time, almost 95% have a B- grade or better, with names at the very top of their sectors (the A (+/-) league) accounting for slightly less than 79%.

Also, in my articles, I frequently address the Return on Assets/Return on Equity spread, and today's piece is no exception. The issue here is that the JMOM portfolio has a phenomenal ROE of over 49%, which is, however, likely skewed by debt-heavy companies (ex-financials, those with Debt/Equity equal or above 100% account for 35% of the portfolio) as ROA is just at about 10%. Nevertheless, a 10% weighted-average ROA is still a great result in my view; for instance, the median Return on Total Assets from the GICS consumer discretionary sector is 4.2%.

Final thoughts

JMOM is a low-cost exchange-traded fund pursuing mostly large and mega caps with leading risk-adjusted returns. The strategy delivered comparatively strong returns in the past, with 2020 being the most successful year.

Nevertheless, in my view, the current environment is not supportive of momentum-centered portfolios, even of those with a meaningful footprint in quality stocks, as valuation is not a factor to ignore. As illustrated above, JMOM's portfolio is rife with overpriced names, even though on the surface, the earnings yield is marginally above the one offered by the S&P 500. Complacency could cost investors dearly. Amongst the most recent examples, we saw this in March 2020 and, after a long relief supported by expansionary monetary policy, during all the hawkish 2022. In this regard, I would assign a Hold rating to this vehicle for now.

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