"Huge" Rebalancing at Momentum ETF Provides Market-Beating Clues

Ruth Saldanha: At the end of May, the Bronze-rated iShares MSCI USA Momentum Factor ETF, also called MTUM (MTUM), was rebalanced. It is of value for investors to pay attention to what changed in the rebalance. This ETF maximizes exposure to the momentum factor, which is basically the idea that stocks that have been performing well over the short term will continue to do so for some time more. This factor has historically been tied to market-beating performance, which means that if investors keep an eye on what changed in this rebalance, specifically what stocks were added, then they might be able to spot market-beating trends as well. Ryan Jackson is a Manager Research Analyst of Passive Strategies at Morningstar Research Services. He tracks the MTUM ETF and is here today to tell us what he observed with this rebalance.

Ryan, thanks so much for being here today.

Ryan Jackson: Thanks for having me, Ruth. Happy to be joining from a very crowded 10th floor here in the Chicago office.

How Does This Winner-Picking Strategy Work?

Saldanha: Nice. So, let's start with the basics. Let's talk about the momentum factor. How does this winner-picking strategy work?

Jackson: Sure. So, this strategy is really just applying a very traditional momentum investing approach. And like you said, when we think about momentum investing, it's as simple as betting on the stocks that have recently outperformed to continue to outperform in the mid to near future. It's a very simple strategy, and it's kind of a behavioral explanation for why it works based on the idea that we think investors are a little bit too slow to price in new information, we tend to underreact to material news about new equities. So, as a result of that, those stocks can capitalize on those that are performing well recently. In momentum approach, it's worked across different market cap segments, across geographies, across decades, different time periods. So, all in all, the momentum factor is certainly one that's a little bit robust. It's a little bit costly to implement at times, requires quite a bit of trading. So, that can drag on the total returns. But overall, that's kind of the rundown of momentum.

Now, we look at MTUM specifically, it's probably the most common way for U.S. investors to get exposure to momentum in the U.S. market. It's tracking an index called the MSCI USA Momentum SR Variant Index. The way this benchmark is constructed is it's assigning a momentum score to all large and mid-cap U.S. equities, and that score is going to consider these stocks trailing 6 and 12-month risk-adjusted returns. So, it's kind of using those two time periods to quantify recent performance. The 125 best-rated stocks on this momentum score are going to be added to the benchmark and they're going to be weighted by a combination of that momentum score and their market capitalization. So, that's how you build the initial portfolio. And then, twice per year in May and November, we're going to see this index completely rebalance, reshuffle the deck, make sure they're getting exposure to that fresh crop of the best recent performers.

The Momentum Rebalance Shows a Pivot to Growth

Saldanha: So, let's talk a little bit about this rebalance. But before that, let's talk about what's going on with the MTUM ETF. Back in 2021, it had more of a growth tilt, and then in 2022, it became more of a value tilt. So, with this latest rebalance, what tilt is it looking at right now?

Jackson: Yeah, that's exactly right. So, a brief history on MTUM. It's had some seesawing over the past few years. Through the late 2010s, even into the 2020 through the pandemic, it was really all in on growth stocks because those were the companies that have consistently led the market really uninterrupted for a nice long stretch there. But then, starting with a little value mini rally in late 2020, over the next few rebalances, we really saw the fund oscillate back and forth between value and growth as they took turns leading the U.S. market. We saw that most recently in May of last year, 2022, as the fund really piled into the energy, consumer staples, utilities, healthcare stocks, that did a lot better than most of their peers in last year's bear market.

So, go ahead, that brings us to today, or I should say probably about a week ago when MTUM rebalanced most recently, and sure enough, it's looking quite different once again. From a value/growth standpoint, it was in the middle of the Morningstar Style Box, leaning towards value a little bit, with this most recent rebalance swung all the way back firmly into growth territory. Probably an even better way to think about the changes is to think about the sector updates. There are really some pronounced ones. You look at something like tech went from only 3% of the portfolio to 27% after the rebalance, communication services from 2% to 10% and the consumer discretionary stake went from 7% to 14%. So, those were the big increases. Naturally, that space needs to come from somewhere. So, we saw healthcare go from about 39% to 19% of the portfolio, energy dropping from 24% to 5% and some more modest cuts for consumer staples and utility stocks. So, really a big shake up from both the value/growth and a sector perspective for the fund.

Which Stocks Could Be Future Winners? And Which Stocks Were Dropped?

Saldanha: Could you tell us something about the stocks now? What are some major stocks that were included and some that were excluded?

Jackson: Yeah, sure. If you rack your brain and think over the past six months or so about the stocks you feel like you've heard them most about on the news, you can kind of get an idea for where MTUM started to drift because that's what it does, that's by design. So, talking about some of the biggest, newest additions NVIDIA (NVDA) is the headliner. That's been all the rage recently. It's just been shot out of a cannon. We saw some other semiconductor companies break through into the portfolio. Broadcom (AVGO), Advanced Micro Devices (AMD) both came in at over 2% of the new portfolio. Also, some familiar faces. We've got Microsoft (MSFT), Netflix (NFLX), Meta (META). These are all mega cap tech firms that had actually logged previous stints in MTUM but took a little bit of hiatus, found themselves back in the portfolio after the May 2023 rebalance. And then, just some other newcomers that that really earned their way in with strong runs here over the past six months or so, thinking stocks like Chipotle (CMG), General Electric (GE) are a couple more of those newcomers.

As far as those that lost their spot in the portfolio, you can pretty much work your way down the energy and healthcare sectors because the forces that booted a lot of those stocks were more at the sector level than individual. So, when you look at energy, you'll see ConocoPhillips (COP), Chevron (CVX) as a couple of big ones that got booted. UnitedHealth Group (UNH) and AbbVie (ABBV), some of those really strong 2022 performers that just couldn't really sustain that momentum lost their spot as well.

The MTUM ETF is Still a Solid Choice for Momentum Factor Investors

Saldanha: So, help us understand what this means for investors in this ETF? What is your outlook for the fund going ahead?

Jackson: Yeah, sure. I mean, this was a huge rebalance that we just saw in May of 2023. It was 67% of the portfolio turned over, all in one fell swoop here. So, that's a big shakeup. And I think for investors who really just underscores the importance of knowing what you're getting, folks that maybe didn't have a clear idea of how momentum works or what this strategy is doing would be shocked to go to bed one night with one fund and wake up the next morning with a completely different portfolio. But that's just how this thing works, even though over the past few rebalances, they have been more pronounced than usual. So, that's important to remember.

But when you look ahead here, I still think MTUM does a very solid job of tapping into the momentum factor, which over long term has definitely proven its merit. So, that's certainly a good attribute to latch onto. Additionally, you're getting that momentum exposure at a really attractive price point. This ETF only charges 15 basis points per year, which is very, very competitive, hard to beat in the momentum market for sure. And when you look at the process overall, while it does have a couple of flaws, it's got some solid features as well. And I think the pros generally outweigh the cons when it comes down to them. So, that all kind of feeds into our Morningstar Medalist Rating of Bronze, reflects a little bit of conviction that this fund will outperform its category index on a risk-adjusted basis over the long term. So, even though things can get a little bit rocky from one rebalance to the next, I think it's important for investors to get a grip on exactly how this works and stay convicted in it for the long term.

Saldanha: Great. Thank you so much for joining us today with your perspectives, Ryan.

Jackson: Yes. Thank you, Ruth.

Saldanha: For Morningstar, I'm Ruth Saldanha.