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In this post, you’ll discover a simple, step-by-step guide to using a momentum strategy with ETFs. You'll learn how to spot trends in the market and use them to your advantage. This strategy is very easy to follow helps you make more informed investment decisions with less effort. By reading this guide, you’ll gain a practical tool to increase your returns while reducing your risks. This approach is ideal if you want a clear, easy-to-follow method to grow your investments without getting overwhelmed by complex strategies.
ETF Momentum Strategy Background
At the end of last year, I started testing an Exchange traded Fund (ETF) momentum strategy and it's performing great. As I was still experimenting, I invested in small steps and now it is about 15% of my portfolio. Overall, I'm very satisfied.
I Did Not Just Jump on The Bandwagon
Like you I of course I did not overnight decide to implement it, it followed months of research. And it took a lot of convincing.
As you know I'm a hardcore value investor and buying ETFs with the highest momentum (price increase) means you're sometimes buying very overvalued stocks that have been driving the market higher.
But the research was convincing, and I took really good care to limit the risk with good risk management tools - more on exactly how you can do that later.
Why ETF Momentum?
You know momentum is a factor we've built into most of our investment strategies, but I never implemented a pure momentum strategy.
It all started a long time ago when I read the great book by Gary Antonacci called Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk. We also wrote two articles on it which you can read here:
Mastering Dual Momentum: The Art of Combining Absolute and Relative Strength
Meet the inventor and author of dual momentum investing - Gary Antonacci
How To Implement an ETF Momentum Strategy
To implement the strategy, you need the 12 return of a lot of ETFs covering different countries, industries, and investment strategies. If you are a subscriber you can use the data from our ETF Momentum Dashboard or you can use any good ETF data source.
Step by Step Instructions:
Step #1: Sort your list of ETFs by 12 months return from high to low.
Step #2: Remove the ETFs with a return less than the risk-free rate. I use the three months US treasury rate.
Step #4: Sort the list by 12-month momentum from high to low.
Step #5: Invest equal amounts in the top three to five ETF's. BUT make sure that they are not all in the same country, industry or investment strategy to give you more diversification.
Step #6: As ETF trading costs are low you can rebalance as often as you like. I rebalance monthly but every three to six months should work fine.
Why 12 Month Momentum
I use to recommend you use 12-1 month momentum to avoid ETFs that gone up a lot in one month and may correct the following month.
But based on this research report: How to Beat the Market With Just 2 Trades a Year (Backtested 50+ Years of Data) I changes to simply using 12-month momentum. It led to higher returns and is even easier for you to implement.
You Are Jumping on The Fastest Moving ETF Momentum Train
So, in simple terms this is what you do with the strategy. You first look to see what trains are moving forward (beating the risk-free rate), if they are you jump on the train that is moving forward the fastest, the ETF's that have gone up the most.
ETF Momentum Risk Management
Because momentum can turn around fast risk management with momentum strategies is very important.
- Firstly I sell 100% if the ETF breaks the trailing stop loss of 10% or 15% (choose the one you feel most comfortable with). This is tighter than the 20% I use for individual stocks.
- Secondly I sell 50% id the ETF falls below its 50-day Simple Moving Average
- Thirdly I sell the remaining 50% if the ETF falls below its 50-day Simple Moving Average
I also look at the option adjusted high yield spreads in the US as well as in Europe. I do this because of this great piece of research I came across: A Momentum Crash Course - High-yield spreads can predict crashes in long-short momentum portfolios.
They found the following:
There is a strong relationship between the level of high-yield spreads and the one-month returns to the momentum factor. Specifically, tight high-yield spreads are associated with robust momentum premia, while elevated spreads (400-700 basis points) predict weaker returns. The right signal to move out of the momentum strategy—or even to initiate strong bets on reversals—has historically been when spreads exceed 700 basis points.
To track high yield spreads, I use this website: St Louis FED – High Yield Option Adjusted Spreads
If spreads go up over 4%, I start reducing my positions.
Frequently Asked ETF Momentum Investment strategy Questions
1. What is ETF momentum investing?
ETF momentum investing involves selecting ETFs that have shown strong performance over the past 12 months. The idea is to "ride the wave" of these successful ETFs for potentially higher returns.
2. Why should I care about momentum when picking ETFs?
Momentum is important because it can help identify ETFs that are trending upwards. By investing in these, you increase your chances of earning higher returns.
3. How do I choose the best ETFs using momentum?
Start by sorting ETFs by their 12-month returns. Remove those that performed below the risk-free rate. Then, pick the ones with the best 12 month momentum, ensuring diversity in sectors and regions.
4. Is momentum investing risky?
Yes, momentum can be risky because trends can reverse quickly. That's why using risk management strategies, like stop losses, is crucial to protect your investment.
5. How often should I rebalance my ETF portfolio?
Rebalancing monthly or every three to six months is ideal. This helps you stay aligned with the momentum strategy without over-trading, which could lead to unnecessary costs.
6. What’s the 12-month momentum, and why is it important?
The 12 month momentum is simply by how much an ETF’s has increased over the past 12 months.
7. How do I manage the risks associated with momentum investing?
Because momentum can turn around fast risk management with momentum strategies is very important.
- Firstly I sell 100% if the ETF breaks the trailing stop loss of 10% or 15% (choose the one you feel most comfortable with). This is tighter than the 20% I use for individual stocks.
- Secondly I sell 50% id the ETF falls below its 50-day Simple Moving Average
- Thirdly I sell the remaining 50% if the ETF falls below its 50-day Simple Moving Average
I also look at high-yield spreads. When spreads are high, over 4% it's a signal to reduce momentum positions, as momentum may turn.
8. Can I use this strategy with any ETF?
Yes, but it's best to focus on ETFs from diverse sectors and regions. This ensures you aren't overly exposed to one area, reducing your overall risk.
9. Why does this strategy work?
Momentum works because it uses the market’s tendency for trends to continue. By jumping on the fastest "moving trains," you catch the upward ride before it ends.
10. How much of my portfolio should I allocate to this strategy?
Start small, around 10-15% of your portfolio invested in three to five diversified ETF's. Make sure that they are in different countries, industries or investment strategies. As you gain confidence and see consistent results, you can consider increasing your allocation.
