JMOM - SPMO: Momentum Factor Strategy Can Keep Outperforming

2023-04-18 21:06:19 ET

Summary

• SPMO's momentum factor strategy has historically outperformed the S&P 500.
• The semi-annual rebalancing keeps the fund positioned in top-performing stocks from the past year.
• SPMO is a good option for investors with a long-term outlook as a core equities portfolio holding.

The Invesco S&P 500 Momentum ETF ( SPMO ) invests across the stocks from the S&P 500 Index with relatively strong momentum. The attraction here is the market dynamic based on long-recognized academic research suggesting recent winners tend to continue outperforming.

Indeed, SPMO has managed to beat out the benchmark index and the SPDR S&P 500 ETF ( SPY ) over the last several years since its fund inception. With a bullish outlook on equities, we expect SPMO to keep climbing going forward.

What is the SPMO ETF?

SPMO technically tracks the "S&P 500 Momentum Index" which is designed to measure the performance of stocks in the S&P 500 that exhibit persistence in their performance. Simply put, the strategy invests in the top 100 best performers through a market capitalization weighting methodology.

An important point here is the 12-month measurement period utilized in the fund's semi-annual rebalancing, which takes place in March and September. This means that the underlying momentum index is selecting the biggest winners over the past year, which may not necessarily capture the most recent trading action.

That aspect is evident when we look at the current holdings where SPMO is tilted heavily toward Healthcare and Energy sector stocks with a combined 64% weighting compared to only 20% in the S&P 500. Similarly, SPMO is also underweight the Technology sector stocks at just 1.8% of the fund, compared to 26% in SPY.

In terms of underlying holdings, Exxon Mobil Corp. ( XOM ) is the largest single stock position in SPMO with a 9% weighting, followed by Merck & Co., Inc. ( MRK ) at 8%, and Eli Lilly and Company ( LLY ) at 7%. Notably, the top 10 holdings in SPMO do not currently include any Technology sector names.

These weightings are consistent with the relative sector momentum since March 2022, which included the period of extreme volatility last year. Both SPMO and SPY are down approximately -4% over the period with the Energy Select Sector SPDR ( XLE ) up 13% return compared to the 3% gain in the Technology Select Sector SPDR ETF ( XLK ) which we use here for reference purposes.

On the other hand, the sector tilt has become a question mark for SPMO considering the shifting market backdrop where Tech stocks are now outperforming while Energy and Healthcare have become the laggards.

We find that SPMO is down -0.2% year-to-date, and behind the S&P 500 which has delivered a stronger 9% return this year. That spread is explained in part by the 20% rally in the Tech sector within the S&P 500, while Energy and Health Care are threading water with a -1% decline.

From here, the expectation is that SPMO will rotate more into Tech stocks at the September rebalancing while the exposure to Energy and Healthcare will be reduced. Ideally, SPMO will want to see Energy and Healthcare rebound higher over the next several months, which is still possible, independent of the direction tech takes. The rotation more into Tech stocks expected at the next rebalancing will give SPMO a new look with a momentum refresh of sorts.

So while the performance measurement period time lag can be considered a weakness of the momentum strategy, as it doesn't capture the early stages of a trend reversal the understanding is that the strategy isn't intended to outperform over every timeframe. The bigger point is that the rules-based approach works better over several years where the potential for superior risk-adjusted returns can materialize.

Is SPMO a Good ETF?

When we look at SPMO as a whole, the idea here is that the momentum strategy with more targeted exposure that changes over time can be a marginal improvement compared to the broader diversification of the S&P 500. At the same time, if anything, the recent underperformance of SPMO could be a signal for a new entry point if it can lead higher going forward.

We can get caught up in all the technicalities but the reality here is that SPMO should be highly correlated with the S&P 500, in both up and down markets. Still, there are several reasons SPMO with an expense ratio of 0.13% could be a better alternative to the more diversified SPY.

We already mentioned the historical outperformance. According to S&P Dow Jones, the Momentum Index has returned an annualized 12.6% total return over the last 10 years, approximately 40 basis points higher than the S&P 500.

In our view, one advantage of SPMO and the momentum strategy is that it can avoid stocks that perpetually underperform. Companies from every sector that have a deteriorating outlook and poor fundamentals would likely not make the cut for SPMO based on the returns performance.

In this regard, SPMO combines the "quality" of S&P 500 companies with the momentum approach which is in contrast to other momentum ETFs that utilize a broader universe including small and mid-cap U.S. stocks. We find that SPMO has outperformed several alternative ETFs with a similar strategy.

Over the past five years, SPMO has returned 77% compared to just 48% in the iShares MSCI USA Momentum Factor ETF ( MTUM ) which is the largest fund in the category. SPMO also generated a higher return compared to the JPMorgan U.S. Momentum Factor ETF ( JMOM ) and the Vanguard's U.S. Momentum Factor ETF ( VFMO ) over the same period.

Regardless of the market direction, we can say that SPMO has a tested formula that can work through various market cycles. Investors can consider SPMO as a core portfolio holding or tactically added for incremental equities exposure.

Final Thoughts

SPMO does a good job of capturing the momentum factor exposure through a rules-based, low-cost ETF that can work for investors as a core portfolio holding. We believe the fund can generate positive annual returns over the long run.

A bullish case for stocks through 2023 would likely revolve around a sense of macro stability with slowing inflation opening the door for the Fed to back off from the rate hiking cycle. This potential that corporate earnings trend better than expected under a resilient economy should be positive for momentum stocks.

The main risk to consider would be the possibility of a more concerning deterioration of the economy into a deep recession. This scenario including sharply higher unemployment and weaker consumer spending would likely force a reset of equities lower.

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