A Potent Value and Momentum ETF Worth Considering

Alpha Architect Value Momentum Trend ETF VMOT is a well-crafted equity strategy that can take short positions to hedge its market risk. It should hold up better than the MSCI World Index during market downturns and offer competitive returns over the long haul. This portfolio is highly correlated with the global stock market, so it doesn’t offer the type of diversification benefits a market-neutral or managed-futures strategy might. However, it is worth considering as part of an equity allocation.

Strategy Overview This strategy combines value and momentum. Each has been an effective factor strategy over the long term, and they complement each other well. While this strategy incorporates standard value and momentum selection criteria, this is a distinctive portfolio that screens for quality and has more-pronounced factor tilts than many of its peers. It invests in stocks listed in both the U.S. and foreign developed markets.

The portfolio is structured as a fund of funds. It holds Alpha Architect U.S. Quantitative Value ETF QVAL, Alpha Architect International Quantitative Value ETF IVAL, Alpha Architect U.S. Quantitative Momentum ETF QMOM, and Alpha Architect International Quantitative Momentum ETF IMOM, assigning equal risk weightings to each fund. That means more-volatile funds tend to get smaller weightings, although its dollar allocation across the four portfolios is currently close to even.

Each underlying fund focuses on a single factor and region, so there is very little overlap among them. While this approach dilutes the overarching portfolio’s value and momentum tilts, it still has strong exposure to those factors because each sleeve has very potent exposure to its targeted factor.

Value The two value sleeves start with all stocks with a market cap of at least $2 billion (excluding financials, where Alpha Architect's quality and value screens don't work as well). They first eliminate stocks with potential problems from the eligibility list, including firms with high earnings accruals. High accruals may be a sign that a company is managing its earnings, in which case reported earnings may not paint an accurate picture of the firm's financial condition.

Of the remaining stocks, these funds target the cheapest 10% based on earnings before interest and taxes/enterprise value multiples, which is a very high threshold for inclusion. Unlike earnings/price, EBIT/EV isn’t influenced by a firm’s financing decisions. That should help the portfolio avoid stocks whose high debt loads make them appear cheap on earnings/price.

From those lists, the value funds target the half with higher quality characteristics to reduce exposure to potential value traps. In the U.S., those quality attributes include strong free cash flow, stable and growing profitability, and financial strength. The foreign value portfolio filters only for financial strength in this step because the other data is less reliable here. Only around 40-50 stocks are included in each value sleeve, and they receive equal weightings to better diversify risk.

Momentum The two momentum sleeves start with a similar universe as the value sleeves, but they include financials. These portfolios rank stocks on their total returns over the past 12 months, excluding the most recent one, and screen for the top-scoring 10%. These portfolios screen those stocks on the quality of their momentum, favoring those with more consistent positive returns. The idea is that investors are more likely to underreact to the improving fundamentals of stocks with gradual momentum than stocks with quick bursts of strong performance. Only around 40-50 stocks make the cut in each sleeve, but they are equally weighted.

The momentum portfolios are rebalanced one month prior to each quarter-end to profit from window dressing (where active managers may clean up their portfolios and buy recent winners, so they’ll look smarter when they report their holdings) and tax-loss harvesting at the end of the year.

Because of its equal-weighting approach and aggressive pursuit of value and momentum, the fund tends to have a much smaller market-cap orientation than the MSCI World Index. And it can have big sector tilts, as it does not make any adjustments for sector membership in its stock-selection approach.

Trend-Following To mitigate risk, the fund incorporates two trend-following signals: One looks at whether the S&P 500's price is above its 12-month moving average, the other at whether its returns over the past 12 months exceed those of 90-day Treasury bills. The managers also apply these signals to the MSCI EAFE Index. If both signals show that one of the markets is below trend, the managers completely hedge their exposure to that market by shorting an instrument that tracks the S&P 500 (in the case of the U.S.) or the MSCI EAFE Index (for international stocks). If only one of the signals suggests the market is below trend, they apply only a 50% hedge in that market.

Even when the fund has a full hedge on in both markets, it will probably still have positive net exposure to the market because it is always long its two value and two momentum portfolios, which tend to have higher betas than the corresponding short positions. This also means that the fund always has exposure to value and momentum style risk, along with any accompanying sector bets.

Alternatives There aren't any close alternatives. While it's feasible to apply this type of trend-following strategy to any set of exchange-traded funds, this strategy is probably more tax- and cost-efficient than a do-it-yourself approach.

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