ETF: Understanding momentum ETF strategies

While ETFs weighted by market capitalisation get the diversifying job done, ETF issuers can’t all offer the same products. Enter factor investing! Factor-based ETFs only invest in companies whose share prices or fundamentals share certain characteristics. In this post, we are going to look under the hood of South Africa’s two momentum ETFs.

Not following? We explain the differences in methodology in this post.

What is momentum investing?

The principle behind momentum investing is simple: if a share price starts going in one direction, it’ll probably keep going in that direction. A share price that increased for a whole year will likely continue to do so.

This phenomenon comes down to “herd mentality”. When we see a share price going up, we want to be part of the action. We buy the share, pushing the price up further. Our friends see the price going up even further and pile in on the action, sending the price up once again.

This also applies in the other direction. When everybody starts selling a share, we don’t want to hold on to it, so we sell ours too. This pushes the price down even further, which spooks everyone who still holds it into selling.

A share is included in these indices if its price has been rising for a period. It gets booted out when that’s no longer true. To keep up with the changing environment, these ETFs are re-weighted more often than ETFs weighted by market capitalisation.

South African index investors can choose between two momentum ETFs. While the principle of momentum investing are at the heart of these two ETFs, how they achieve their momentum exposure differs dramatically. Below we will investigate how the Satrix Momentum ETF (STXMMT) differs from Absa’s NewFunds Equity Momentum ETF (NFEMOM).

Starting universe

Because these ETFs are often rebalanced, the biggest concern is easily buying and selling the shares that need to be in the index. Both ETFs aim to eliminate shares that can’t be bought and sold at a moment’s notice. This is important, because the ETF has to be able to sell the shares when they no longer exhibit the momentum characteristics we discussed above.

The Satrix Momentum ETF looks at all the non-property stocks on the JSE, including mid-cap shares. From here, shares that don’t trade often enough are excluded.

The NewFunds Equity Momentum ETF is also concerned with liquidity. For that reason it starts with the top 60 most liquid shares on the JSE. To make 100% sure the shares can be sold, this ETF also excludes shares that haven’t traded at all for 5% of the time, even if they fall into the initial top 60.

Number of holdings

The Satrix Momentum ETF invests in 40 shares, while the NewFunds product only invests in 20.

Rebalancing

As mentioned above, these ETFs are all about price movement. For shares that are in demand, share prices in the market can change every second. To keep up with this ever-changing environment, these ETFs have to be rebalanced more often than ETFs weighted by market capitalisation.

The Satrix product is rebalanced eight times per year, while the NewFunds product is rebalanced every month.

Rebalancing often makes sense in this case, but one of the perks of index-investing is avoiding rebalancing all the time. Every time an ETF rebalances, there are costs involved. Not only do ETF issuers have to pay brokerage fees like we do, the difference between the buy and sell price in the market is also considered a cost.

Weighting

This is where things get really interesting. The Satrix product has a more traditional approach to how much space each share can take up. The index looks at the difference between the price of a share over a six- and 12-month period and ranks the shares accordingly. They also factor in earnings forecasts of these companies in a similar way. The bigger the differences, the higher the weighting.

The NewFunds product takes a more interesting approach. Instead of looking at how much a share price moved, this product tries to make sure that no share adds more risk than any other. Highly volatile shares can take up less space. Shares with low volatility take up more space. This product tries to ensure a smoother ride by stripping out some of the influence of the cowboys.

This NewFunds ETF further strips out noise by excluding the previous month’s data. Because prices move a lot on a day-to-day basis, a share price that has only risen for one month is not necessarily a momentum share. In other words, a share is only considered a momentum share if the price has risen for two consecutive months.