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Gains in Momentum

Use this screen to find ETFs that hold strengthening companies that are still undervalued.

Timothy Strauts, 12/06/2012

This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000. 

The strongest and most persistent factor strategy is momentum. Stocks that have performed best over the past year have higher returns than stocks that have performed worst. Momentum strategies have consistently outperformed standard long-only market strategies. We’ll use this screen to find exchange-traded funds that hold companies whose returns are gaining strength.

( U.S. Broad Asset Class = U.S. Stock
Or U.S. Broad Asset Class = Sector Stock
Or Leveraged Fund =  No
Or Net Assets Share Class > 250 million)

For this screen, we will focus on the domestic stock ETF universe. We’re not interested in leveraged products, so we’ll remove those from the search. When looking at potential ETF investments, you want adequate liquidity. One of the easiest ways to make sure you’ll be able to buy and sell with reasonable bid/ask spreads is to only consider ETFs with more than $250 million in assets.

And Total Return 1 Yr (Mo-End) > 32%

Momentum is a strategy of buying investments that have had strong returns over the past six to 12 months. The strategy is based on the idea that markets aren’t random and that trends exist. Research has shown that momentum generates outperformance in almost every market and asset class tested. Momentum’s profitability may seem to contradict the fact that many retail-level performance-chasers underperform the market. There is no contradiction. These investors lose out because they hold on to hot investments for far too long, riding collapsing trends down.

Why does momentum work? A stylized version of the story goes like this: In light of surprising or extreme news, investors “anchor” new price estimates to old prices. They are also loath to realize losses, preferring to keep dogs until they break even, and they are too quick to sell winners. Both biases also keep prices from instantly reflecting new information. Instead, prices slowly adjust to fair value, creating sustained price movements, up or down. Once an upward (or downward) trend is established, investors over extrapolate recent performance and herd in (or out) of the asset, further accentuating the trend. Over the medium term, the trend collapses after the market realizes it has overshot.

To find areas of the market that are still undervalued, we will lean on Morningstar’s equity analysts for guidance. Morningstar has 125 equity and credit analysts who conduct fundamental analysis and derive fair value estimates for more than 1,800 companies worldwide. Because this data can be aggregated to the fund level, we can form an estimate of intrinsic value for equity ETFs, which are simply worth the sum of their constituent parts. So a price/fair value less than 1 is undervalued. By combining a value and momentum metric together, our goal is to find undervalued securities with good momentum.

And Price/Fair Value < 1

Timothy Strauts is an ETF analyst at Morningstar.

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