Everyone loves a winner and that applies to stocks as well. While the popular finance theory “Random walk” states that the past movement of the price of a stock cannot be used to predict its future movement, history shows that recent past performance can be a pretty good predictor of short-term future performance.  (Read: 3 Biotech ETFs Crushing the Market in 2015)

Momentum Effect Documented in Academic Studies

It has been more than two decades since the academic discovery of "momentum effect" in stocks; Jegadeesh and Titman documented  in 1993 that strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. The study further found that the profitability of these strategies is not due to their systematic risk or to delayed stock price reactions to common factors. 

The momentum effect was seen in almost all the markets studied and in time periods going back to more than 200 years. A study by AQR Capital Management, found that best momentum US stocks outperformed worst momentum ones by more than 10% a year between 1927 and 2010. Reasons for this outperformance are not difficult to understand. Enthusiastic investors love pouring money into high fliers, even ignoring fundamentals at times. (Read:  3 ETFs Surging at the Start of 2015)

Price Momentum Driven by Earnings Momentum?

Although momentum investing involves price action as the determinant of momentum, stock prices are mostly driven by earnings growth—actual as well as expected. At Zacks, we strongly believe that earnings momentum drives stock prices. So, momentum stocks are usually stocks of companies that have been doing the right things and showing strong growth potential.

Momentum as a Complement to Value

On the face of it, value investing strategy looks virtually opposite of momentum since it involves purchase of healthy companies with solid fundamentals that have been ignored by investors. In fact, value and momentum strategies exhibit negative correlation and while momentum strategies work in shorter time periods, value strategies deliver returns over longer term. (Read: Bet on These Top Ranked Tech ETFs for Outperformance)

A simple combination of these two strategies can be very effective in boosting portfolio returns while hedging risk (learn more about this strategy in my forthcoming article on the topic).

ETF Options Available to Investors

Momentum investing strategies have grown in popularity and there are a number of ETF choices available that provide a diversified, low-risk way to profit from these strategies. Below, we have discussed 3 popular choices in this space.

First Trust Dorsey Wright Focus 5 ETF (FV- ETF report)

The investment approach of this ETF is primarily based on technical analysis, with a focus on relative strength.  Relative Strength, in simple words, is used to measure a security’s price momentum relative to its peers. The relative strength analysis is conducted on a weekly basis and the index is accordingly rebalanced.

FV is actually a “fund of funds” that consists of the top five ranked First Trust sector and industry ETFs as identified by their relative strength rankings. So instead of focusing on individual stocks, this ETF focuses on sectors whose price action is superior to others in the universe. Currently the fund has highest exposure to ETF following Biotech, Healthcare and Internet industries.

The product is one of the most successful launches in 2014. It made its debut in March last year and has already managed to attract more than $2.5 billion in assets.

It is slightly pricey due to its “enhanced indexing” approach, with an expense ratio of 95 basis points. So far it has more than justified its higher fee with a market crushing return of 25.9% over the past one year.

iShares MSCI USA Momentum Factor ETF (MTUM - ETF report)

This ETF seeks to track the performance of large- and mid-cap US stocks exhibiting relatively higher momentum characteristics. It was launched in 2013 and has managed to attract more than $600 million is assets so far. With an expense ratio of just 15 basis points, this is the cheapest option in the space.

In terms of sector exposure, the ETF is tilted towards Healthcare sector (32% of the asset base), followed by IT (23%) and Consumer Discretionary (12%).  Apple is currently the top holding of the fund, with Microsoft, Gilead Sciences, J&J and Amgen rounding out the top five.

MTUM has returned 17.5% over the past 12 months compared to 15.5% return by the broader market SPY.

PowerShares DWA Momentum Portfolio (PDP - ETF report)

PDP is based on Dorsey Wright Technical Leaders index which selects 100  large- and mid-cap US stocks based on, among other factors, their performance relative to other stocks in the universe as also the relative performance of industry sectors and sub-sectors. The ETF is rebalanced quarterly.

The ETF made its debut in 2007 and is now one of the most popular options in the space with $1.9 billion in AUM. It is however pricier compared with MTUM, with an expense ratio of 65 basis points.

The product is heavily exposed to the Consumer Discretionary sector (28% of the asset base) followed by Healthcare (21%) and Industrials (17%). Jazz Pharmaceuticals, Apple and Regeneron Pharmaceuticals are the top three holdings currently.

PDP has returned 17.6% over the past 12 months compared to 15.5% return by the broader market SPY during the same time frame.

The Bottom Line

These ETFs offer a great way to profit from the momentum strategy, which is based on the fact that winners over the past few months tend to continue to outperform in the short-run. Investors however need to remember that these strategies will tend to underperform during market corrections.

At the same time, with a growing US economy and still accommodative monetary policy, I do not expect a severe correction in the stock market anytime soon.