BlackRock’s US momentum ETFs underwent a long-overdue swing to value at the end of May – some six months after markets began their rotation away from growth stocks.
Coming back into the loop, the iShares Edge MSCI USA Momentum Factor UCITS ETF (IUMF) and its US counterpart recently began mirroring the cyclical sector trade, around half a year after ‘old economy’ equities began their recovery following the publication of Pfizer’s vaccine results.
Among IUMF’s roster overhaul, tech names such as Amazon, Apple, Microsoft, Adobe and Nvidia were removed entirely, while blue-chip value names such as JP Morgan, Berkshire Hathaway and Bank of America made an entrance.
Following the rebalance, IUMF’s weighting to financial stocks jumped from 1.5% to 32.5%, while energy firms were introduced to the strategy with a 1.9% allocation. Meanwhile, the tech sector’s stake in the ETF was slashed from 42% to 18%.
Too much, too late?
These swings in sector weighting are drastic but ultimately delayed. Having been underweight cyclicals, IUMF has returned 5.4% since the start of the year, versus 11.5% for the iShares MSCI USA UCITS ETF (CSUS), which tracks the parent US index.
This deficit is purely the result of IUMF’s index methodology, which has two clear shortcomings: semi-annual rebalancing and rebalancing based on data from the previous month.
Combined, these features mean not only can it potentially take months before investors’ portfolios begin mirroring market shifts but once a rebalance does occur, it is based on data that is already a month old. In effect, before its recent rebalance, IUMF was based on the top momentum stocks of October 2020.
Commenting on the products’ index construction, Todd Rosenbluth, head of ETF and mutual fund research at CFRA, said: “Index-based momentum ETFs can be slow moving vehicles designed to reduce the turnover of the underlying portfolio while capturing exposure to the factor.
“However, when there is a leadership change in between review periods there can often be whiplash as the ETF catches up.”
Matthias Hanauer, director of quant selective research at Robeco, added that a twice-yearly rebalancing makes the momentum strategies highly sensitive to the subjective choice of when to rebalance and can result in ‘substantial’ deviations from the desired factor exposure.
On IUMF’s recent rebalance, Hanauer said: “If the index had already been rebalanced at the end of April, the strategy would have benefitted from value’s good performance in May.”
Now IUMF and its US counterpart have reshuffled, Rosenbluth said CFRA’s research underestimated how heavily the ETFs would weight to sectors such as financials. He now questions whether the new basket of stocks can maintain their strong performance, given their rallies began around the turn of the year.
Sluggish direction change
However, another concern is not just how overdue and swathing the IUMF rebalance has been but the laboured nature of the rebalance itself.
Research by Robeco shows a large portion of rebalancing trades exceed a stock’s average daily trading volume, with this raising potential liquidity issues for ETFs such as IUMF which rebalance infrequently, offloading and picking up large portions of its portfolio in short, dramatic swoops.
With market cap taken into consideration during IUMF’s allocation process, liquidity concerns do not represent a danger to the ETFs but do offer a costly window for arbitrage by external participants such as hedge funds.
"Stocks that are announced to be added to the index rise in price before actually being included in an index, while the opposite effect is observed for deletions,” Hanauer continued. “Both effects are disadvantageous for index investors as an ETF on the index buys the additions at a higher price and sells deletions at an already lower price. These effects become larger as assets in smart beta ETFs grow.”
As far as cures for these ailments are concerned, a complete methodological overhaul is needed and one that more closely represents the ETFs’ raison d’etre.
Investors using momentum strategies are not looking to perform tactical allocations using ETFs but rather achieve alpha through an ETF that tactically allocates internally – and that means a product which moves at least close to when the market moves.
One way to achieve both proactive reweighting and faster completions on rebalances would be to apply an active management methodology. This, in turn, would create an opportunity for timely allocations and by spreading trades out into smaller, more regular chunks, would create higher capacity within momentum ETFs by using the liquidity offered by the market throughout the year.
Offering a word of warning, Rosenbluth noted:“Actively-managed ETFs have increased flexibility to adjust although they can make the wrong decisions.”
Furthermore, the cost of active management and a dozen rebalances a year should not be overlooked.
Offering something of a fix, Athanasios Psarofagis, ETF analyst at Bloomberg Intelligence, said European momentum ETFs should look to products such as the Vanguard US Momentum Factor ETF (VFMO), which has discretion over the timings of rebalances.
“One thing it can do is do it in sleeves, meaning it breaks the ETF into 12 sub portfolios,” Psarofagis said. “It does not rebalance the whole thing in one shot but rebalances 1/12 monthly.”
This highlights the challenges with momentum ETFs that rebalance only twice a year. In a rapidly changing market environment, the strategies can be slow to catch-up meaning any hope of outperformance, especially in the short term, is most likely wishful thinking.