Momentum-Based ETF Selection

04/23/2014 7:00 am EST

Focus: ETFs

I’m always on the prowl for rebalancing opportunities—in particular, those moments when the odds look unusually high for success in one or more ETFs, says James Picerno of Capital Speculator.

Instances of screaming buys or sells are rare, of course, and when they do arrive, the low-cost lunch doesn’t last long. Accordingly, it’s essential to monitor the ebb and flow of markets on a regular basis so that you can grab a pearl before it turns back into a sow’s ear.

I usually start by comparing assets by way of price momentum. There’s a deep pool of academic and empirical research that tells us that this is a potent risk factor that explains a lot of what’s driving short-term performance. The challenge is figuring out how to define momentum—an essential component for systematically reviewing markets in search of the most-compelling rebalancing opportunities. There are many possibilities, but I prefer to stack up current prices against the median of several exponential moving averages and then transform the data into percentile ranks. The goal is developing a quick reference point for deciding how recent price action compares with history. As an example, let’s consider some ETFs that represent the major asset classes and US equity sectors.

Foreign REITs/real estate currently ranks highest for short-term momentum for our usual list of ETF proxies for the major asset classes. The Vanguard Global ex-US Real Estate ETF (VNQI) is at the 76th percentile. This isn’t yet at the outer edges, but it’s close and so this ETF warrants attention in the days ahead as a possible candidate for selling.

chart
Click to Enlarge

chart
Click to Enlarge

Switching over to sector ETFs suggests that energy (XLE) is running a bit hot if not overheating. The SPDR Energy Select Sector SPDR (XLE) tops the list in this corner for short-term momentum, reaching the 85th percentile rank as of last week’s close.

chart
Click to Enlarge

chart
Click to Enlarge

Can you count on momentum as a flawless signal for calling tops and bottoms? No, of course not. But as one aspect of a broadly defined risk-management process, the momentum factor is a powerful tool. The strongest signals arise when price momentum is extreme. That’s a high standard, and none of the ETFs noted above are in that category. But some are getting close. Be careful, however, as you could miss it if you blink. The state of excess in matters of price momentum is a fleeting event, although it typically offers the most attractive odds for success for exploiting mean reversion. The ripest fruit of expected risk premia never hangs on the vine for very long, but when you grab it at the right moment—if you can—it’s the closest thing to bliss in Mr. Market’s orchard.

By James Picerno of Capital Speculator

Related Articles on ETFs

Keyword Image
The Omen
12/07/2017 10:50 am EST

The probability of an equity market correction over the next few months is slim to none, so there co...