A version of this article previously appeared in the August 2020 issue of Morningstar ETFInvestor. Click here to download a complementary copy.
While the academic definition of momentum is straightforward, the way it is defined and implemented by practitioners is often anything but. A lot happens when momentum descends from the ivory towers of academia and steps into the harsh reality of Wall Street. Long-only constraints, transaction costs, and taxes all take a lot of the oomph out of momentum.
Momentum exchange-traded funds take different approaches to portfolio construction, attempting to retain the benefits of the momentum factor in its purest form and address some of its potential drawbacks. Navigating these nuances can be challenging. Having a solid framework for understanding them is critical.
Selection Universe In assessing momentum strategies, investors should first make note of the selection universe. This represents the fund's opportunity set: which stocks are in play and which aren't.
In the case of momentum ETFs, some start from a broad selection universe, while others are narrower. For example, SPDR S&P 1500 Momentum Tilt ETF MMTM draws from the biggest pool of any index-tracking momentum ETF. Its selection universe spans all U.S. stocks large to small, and it had an aggregate market cap of nearly $31 trillion as of July 31, 2020. Invesco S&P SmallCap Momentum ETF XSMO resides on the other end of the spectrum: Its parent index, the S&P SmallCap 600, had an aggregate market cap of $726 billion as of July 31.
Momentum is fickle. It ebbs and flows across market cycles, sectors, and market-cap strata. Exhibit 1 shows how momentum stocks' leadership can move up and down the market-cap ladder. This relative wealth plot pits the S&P 500 Momentum Index against the S&P SmallCap 600 Momentum Index. When large-cap momentum stocks outperform small-cap ones, the line moves up, and vice versa. Momentum was strong among the market's biggest stocks during the tech bubble. When the bubble burst, momentum reversed violently. In recent years, we've seen large-cap momentum stocks outperform their smaller counterparts once again.
There is no sense in trying to time these shifts. Selecting a momentum fund that draws from the deepest well of stocks will increase investors' odds of staying on top of momentum, wherever it may roam.
Selection Criteria Standard academic momentum is measured by taking stocks' total returns over the past 12 months and excluding the most recent month. Excluding the most recent month's returns accounts for the short-term reversal effect, whereby stocks that have performed well during the past month tend to perform poorly the following month, and vice versa. The academic momentum factor goes long the stocks with the strongest momentum by this measure and shorts those with the weakest momentum. Momentum-focused ETFs all use some version of this academic standard to pick stocks. But each has its own unique twist on the classic formula.
Many momentum ETFs include a volatility- or quality-adjusted momentum metric. This helps to weed out stocks that feature a bolt-of-lightning brand of momentum that might be less likely to persist. For example, a biotech stock that spikes higher after releasing favorable clinical trial results will register positive momentum, before accounting for its volatility. These stocks' gains may not persist. Meanwhile, stocks that rate higher on risk- or quality-adjusted momentum measures are more likely to experience persistent gains. This is because the market may be slower to price in positive information regarding their prospects. Adjusting momentum selection measures based on volatility and/or quality will likely yield better results than a raw measure.
Unlike the standard measure of momentum, some ETFs measure momentum over multiple horizons, often adding a shorter lookback period into the mix. This recognizes the fact that momentum can shift quickly. It also reduces the role of luck in the selection equation. Measuring momentum over multiple horizons is good practice.
Weighting Criteria Momentum ETFs take different approaches to sizing their positions. Most consider the strength of stocks' momentum in assigning weights, but there are other criteria at play. Most of these funds anchor stocks' weightings to their market cap, adding or subtracting from their allocation based on how they rank on the relevant momentum measures. Examples include iShares MSCI USA Momentum Factor ETF MTUM and Invesco S&P 500 Momentum ETF SPMO. Other funds take a more aggressive approach. For example, Principal Sustainable Momentum ETF PMOM and Alpha Architect U.S. Quantitative Momentum ETF QMOM both assign equal weights to those stocks with the strongest momentum characteristics.
There are trade-offs involved. Anchoring to stocks' market caps may dilute these funds' factor exposures, but it will also reduce their tracking error relative to their selection universe. Untethering from market-cap weights will likely give these funds a smaller- cap orientation and higher tracking error, resulting in a wilder ride.
Constraints Investors must also consider other constraints that momentum ETFs put in place. For example, single-stock caps promote diversification. Some funds have sector- and size-related constraints. Fidelity Momentum Factor ETF FDMO is both sector- and size-neutral relative to its selection universe. That is, it doesn't make any bets on the performance of one sector versus another or small caps versus large caps. Morningstar research shows that such constraints may have more merit for some factors that demonstrate persistent industry tilts (such as value) than they do in the context of a momentum portfolio, where industry exposures tend to shift.  Momentum investors are probably best served by leaving their sector exposures unconstrained.
Maintenance Momentum is a fast-moving factor. The result is high turnover. The level of turnover of the academic momentum factor would be too costly for real-world application. Momentum funds must strike a balance between maintaining exposure to momentum and the associated costs. With the exception of PMOM, momentum ETFs investing in U.S. stocks rebalance at least twice annually. Actively managed Vanguard U.S. Momentum Factor ETF VFMO decides whether or not to rebalance its portfolio every day.
Most of these funds rebalance like clockwork. Two of them have a feature that may have them rebalance off schedule. Both MTUM and PMOM have features that will result in ad hoc rebalancing in response to extreme market volatility. This feature acts as an airbag of sorts, protecting investors from momentum crashes. This is a useful safety feature for a strategy that has a history of slamming into a wall in volatile markets. 
Conclusion Momentum is tough to harness. Most funds that try fall short. Real-world frictions prevent them from delivering academic momentum in its raw form. Their different approaches to trying to translate academic momentum to practice have yielded mixed results, as measured by both their loadings on the momentum factor as well as their performance versus relevant benchmarks.
Investors should scrutinize these funds' processes and understand their selection universe and how they select stocks from it, how those stocks are weighted, whether there are any constraints in place, and what the ongoing maintenance schedule looks like. We think that funds that account for risk, leave constraints aside, and account for momentum's tendency to crash every so often are best-of-breed. Of the 11 funds listed in Exhibit 2, MTUM is our favorite. The fund has earned a Morningstar Analyst Rating of Silver.
 Bryan, A., & McCullough, A. 2017. "The Impact of Industry Tilts on Factor Performance." https://www.morningstar.com/content/dam/marketing/shared/pdfs/Research/The_Impact_of_Industry_Tilts_on_Factor_Performance.pdf
 Daniel, K., & Moskowitz, T.J. 2016. "Momentum Crashes." Journal of Financial Economics, Vol. 122, No. 2, P. 221.
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