Looking At The Smartest ETF In The Room

Here's an interesting thread from Twitter that asks "what's your favorite ETF?" Most of the answers fell into one of two categories, broad based stock market index funds from Vanguard and dividend ETFs from various providers. One answer stood out to me that sent me down a rabbit hole to try to learn more was a mention of the Alpha Architect US Quantitative Momentum ETF (QMOM).

QMOM scores the 1500 largest domestic stocks for momentum and then applies a "quality" screening process which gives them top momentum names with the lowest relative volatility to populate to ETF. I think I've got that right. It worth mentioning the serious brain power underlying all the Alpha Architect ETFs, Wes Gray, Jack Vogel and Ryan Kirlin are very smart and as I try to understand the fund it is worth invoking a great quote from Deadwood when Hearst says to Bullock "I'm having a conversation you cannot hear." Gray, Vogel and Kirlin might be having a conversation I cannot hear.

I remember hearing about QMOM a while ago, someone very bullish on the back test Tweeted something like "just put it all in QMOM and forget about it." I would note that 10 years earlier, someone commented on my blog to "just put it all in Hussman and forget about it." Hussman as in Hussman funds which arguably missed the entire bull market from the end of the financial crisis through to the end of 2021.

While "put it all in..." is not something I would recommend, the thought stuck with me. I asked the person in the current thread why they answered QMOM. They said they were impressed by the backtest and the thought process underlying the strategy and shared this link to a short paper by Larry Swedroe posted on the Alpha Architect website. One interesting nugget from the paper is that dramatically improving momentum only resulted in an increase to beta of 0.2%. There's other math about outperformance but also the observation that momentum is prone to crashes. Yesterday, I spent some time playing around with QMOM's chart and drew a conclusion that I will get to shortly that ties in with Swedroe's observation of being crash-prone. 

The paper has more data showing that when it works, it works. It's interesting that there's a Lindy element to momentum, the longer something outperforms, the more likely it is to continue outperforming. Until it doesn't? 

 

The chart compares QMOM to the iShares MSCI USA Momentum Factor ETF (MTUM) and the S&P 500 from QMOM's inception to the end of 2021, so no bear market effect. Not so fast though on the "no bear market effect" as both QMOM and MTUM turned lower before the S&P 500. They may have been a canary in the coal mine for the broad market. You don't see that before the 2020 Pandemic Crash though. The current event, rolling over slowly is more typical of bear market behavior as opposed to the crash in 2020. The momentum funds also did not provide early warning for the downturn in late 2018. 

Here's the last year.

 

And year to date.

 

What I think is happening with QMOM in both these charts is the bias to quality is acting like a bias toward value, makes sense, and value is holding up much better in the bear market, beating growth by about 1300 basis points. MTUM doesn't have a quality (value) screen its process so it is not getting that effect the way QMOM did. 

Back to Swedroe's observation about being crash prone. QMOM fell about 5% more than the S&P 500 in the Pandemic Crash but coming off the Pandemic low, it rallied much more, gaining 77% in six months off that low versus 46% for the S&P 500 and 54 % for MTUM. Buying bottoms is not something you can count on doing but even if you missed the bottom by a month, the six months from late April had QMOM up 56% versus 23% for the S&P 500 and 31% for MTUM. 

When the stock market started falling in September 2018, QMOM provided no early warning like I said, but it fell much more into the December 24th, 2018 bottom, 31% vs 19% for the S&P 500 and 20% for MTUM. Off the Christmas Eve bottom, it gained 35% compared to 22% for the S&P 500 and 25% for MTUM. Again, if you missed that bottom by a month, QMOM still outperformed, up 22% versus 13% for the S&P 500 and 16% for MTUM.

If your eyes just glazed over there, the takeaway is that QMOM's track record is going down more than the broad market (crash prone), rallying much fast off of bottoms than the broad market and rallying much faster even if you were a month late for picking the bottom. 

There's one other chart to capture.

 

In early 2021 QMOM spiked dramatically versus the S&P 500. Starting the chart two years ago, it gained 76% versus 20% for the S&P 500 and then reverted to the mean viciously. One year on from that peak on Feb 8, 2021, it fell 24% versus a gain of 17% for the S&P 500. I'm not sure what caused that spike.

What is the takeaway here? I think quite the opposite of putting it all into QMOM and forgetting about it, this is a fund to be very tactical with. If being tactical isn't your trade, I would not buy the fund. If being tactical is something you're comfortable with then at some point as the market bottoms, remember you can be a month late, it seems like there is another chance for it to outperform again. Down about 20% on the S&P 500 doesn't feel like an over reaction to the current event as opposed to down 33% in just a couple weeks back in 2020. I've mentioned a very slight re-equitization down around 24% back in June with the idea of buying more down somewhere worse than 30%, I would consider QMOM for that trade, if it ever comes to me. 

If all those stars lined up and then it actually outperformed by a wide margin as it has before coming off bottoms, it would need to be sold. If there was ever some sort of crazy spike like early 2021, regardless of coming off of a bottom, I would say that needs to be sold too. 

The risk to the trade as I am outlining is that as a factor, it might underperform a market cap weighted fund. The scenario of QMOM dropping a ton when market cap goes up would only happen, IMO, after another period of crazy outperformance for QMOM. That might never happen again but if it does, don't buy it and if it happens while you own it, then sell it. Tactical, I don't see buying and holding forever.

Note, I am not expecting to time the bottom. I set one target to add a little more and stuck to it, so far so good on that. I also set another target to buy more that hasn't happened yet but I will stick to that too if it happens. That sort of approach might catch a bottom or two over a longer period but the mindset is much more about a disciplined process for buying after large declines irrespective of where the bottom is.