Momentum has been a winner so far this year, outperforming the broader equity market globally, in the US, and in Europe – by a double-digit percentage-point margin in the former two regions.
That is price momentum, however – a factor prone to sharp downturns when sentiment sours. A new ETF will instead focus on earnings momentum, which should in theory be underpinned by something more solid than enthusiasm.
A new direction?
The PowerShares Tradable European Earnings Momentum Factor ETF – announced alongside other new PowerShares factor ETFs for European value, quality, low beta and price momentum – is a rarity in defining momentum in this way. Its ongoing charge will be 0.3%.
This should be a welcome addition to the world of factor products. In a 2015 paper, Professor Robert Novy-Marx showed that ‘price momentum strategies do not have a positive alpha relative to earnings momentum strategies, while earnings momentum strategies have large, highly significant alphas relative to price momentum strategies’.
In other words, earnings momentum is the real factor worth owning and price-based approaches have only been weak proxies bought because they were the only option. ‘This suggests that an investor who wants to trade momentum would lose nothing by completely ignoring price momentum,’ argued Novy-Marx.
That should not be read as a straightforward endorsement of the new ETF, though. Novy-Marx based his study on actual earnings surprises, but the PowerShares methodology has a different process.
Its underlying Solactive index instead measures earnings momentum with reference to the percentage change over the preceding three months in consensus analyst earnings estimates for the next two fiscal years.
It is thus more reliant on market sentiment than delivered earnings growth and will inevitably invite cynicism from those who criticise equity analysts’ track records as well as scepticism from those wondering about the impact of Mifid II on that community and what they publish.
So what stocks has this approach captured? The index – comprising 50 companies assigned a weighting of 1.5%, 2% or 2.5% depending on their liquidity, and rebalanced monthly – entered November most exposed to financials and industrials at the sector level and the UK and Germany by country.
Solactive’s price momentum index has similar sector allocations, but its weighting to the UK is 20 percentage points lower.
In terms of individual stocks, the largest positions in the earnings index going into November were UK software group Micro Focus, luxury retailer Kering, airline Lufthansa, and steel manufacturer ArcelorMittal.
Kering and Lufthansa also feature prominently in the price momentum index, unsurprising after gains of 80% and 134% respectively so far this year.
Micro Focus is a more curious case. It is up by a more modest 17% in 2017, although that is still far in excess of the FTSE 100. Its earnings estimates, however, will presumably have been buoyed by its £6.6 billion acquisition of Hewlett Packard Enterprise’s software business earlier this year.
ArcelorMittal – up 13.5% this year – also underwent a reverse stock split in May, whereby every three old shares were consolidated into one new share, which could have flattered earnings-per-share numbers unless properly accounted for in the aggregation of estimates.
Nevertheless, such issues have not dented the performance of the earnings momentum index. It returned 21.4% in the first 10 months of the year, ahead of both the 18.8% from the Solactive price momentum index and the 15.9% from the more diversified MSCI Europe Momentum index, all denominated in euros.
Earnings momentum also beat price momentum by a wide margin, of 6.8% to 0.01%, in 2016 and by 18.1% to 7.8% in 2014. In the outlier, 2015, price outperformed earnings by 24.6% to 17.7% as an escalation in the European Central Bank’s stimulus efforts early that year proved more important than fundamentals.