Momentum Investing with ETFs: Practical Guide

The Anomaly That Shouldn't Exist

Momentum is the tendency of assets that have performed well over the past 6 to 12 months to keep outperforming over the next several months, and for recent losers to keep lagging. It is one of the most thoroughly documented patterns in finance, found across stocks, countries, bonds, and commodities, and across more than a century of data. In an efficient market it arguably shouldn't exist, which is part of why it's so studied.

The leading explanation is behavioral: investors underreact to good news at first, then pile in as a trend becomes obvious, pushing prices past fair value before they eventually reverse. Whatever the cause, momentum is a real, persistent factor that academics like Jegadeesh, Titman, and later Fama and French have measured repeatedly. The practical question is whether you can capture it after costs.

Capturing Momentum in a Single Fund

You don't have to rank thousands of stocks yourself. Factor ETFs do it mechanically. The best-known is MTUM, iShares' U.S. momentum fund, which screens large- and mid-cap stocks on their recent risk-adjusted returns and rebalances periodically to hold the strongest. Its expense ratio sits around 0.15%, far cheaper than an active momentum manager, and it does the ranking and turnover for you.

Because momentum requires regular reshuffling, these funds have higher turnover than a plain index fund, which can make them less tax-efficient in a taxable account. They also look very different from the market at any given moment: a momentum fund can be heavily concentrated in whatever sector is currently winning, which is a feature in a strong trend and a liability when that trend snaps.

Momentum Crashes: The Catch You Must Know

Momentum's long-run record comes with a vicious tail. The factor is prone to sudden, severe "momentum crashes" that happen at market turning points. After a deep bear market, when the rally finally comes, the biggest bounces are usually in the beaten-down stocks the momentum strategy has just sold, while the recent winners it's now holding lag badly. The 2009 rebound is the textbook example, when momentum strategies suffered some of their worst losses precisely as the broad market recovered.

This is why momentum can't be treated as a free lunch. It has historically delivered a premium over long horizons, but it earns that premium partly by taking on crash risk that shows up rarely and painfully. An investor who buys a momentum fund after a great run and bails during the next reversal can easily capture the downside without the long-run upside.

Where Momentum Fits in a Portfolio

Momentum is best used as a diversifying factor tilt, not a core holding. Because it has historically had low correlation with value, the two factors can offset each other: value tends to do well when momentum crashes and vice versa, so pairing a momentum fund with a value fund like VTV smooths the ride. Some multi-factor funds bundle momentum, value, quality, and size into one product to capture this internally.

If you hold momentum, hold it in a tax-advantaged account where its higher turnover doesn't generate a tax bill, size it as a satellite rather than the foundation, and commit to holding through a crash. The factor's edge has only ever shown up for investors who stayed through the bad stretches. Treating it as a way to chase whatever's hot this quarter is how you end up with the risk and none of the reward.

• Use momentum as a satellite tilt, not the core of the portfolio.
• Pair it with a value fund like VTV, since the two have historically been lowly correlated.
• Hold it in a tax-advantaged account to absorb its higher turnover tax-free.
• Commit to holding through a momentum crash — the long-run edge only accrues to those who stay.