XMMO: Momentum Strategy Working For Mid-Cap Stocks

(This article was co-produced with Hoya Capital Real Estate)

Introduction

With Large-Cap stocks like those held by the SPDR S&P 500 ETF (SPY) performing so well, why worry about gaining exposure to Mid- or Small-Cap stocks is a valid question. Recent history does not match long-term history is one reason; another is simple diversification. The next chart shows the three market-cap size returns from 1994-2021.

Data back to 1972 shows the same results, with Mid-Cap being the top performing market-cap section. If that is the case, maybe tweaking the basic selection rules can enhance the return. The Invesco S&P MidCap Momentum ETF (NYSEARCA:XMMO) believes their ETF can provide extra return by selecting and weighting their holdings by a momentum factor. Since it launched in April of 2005, the strategy has proven its worth compared to the standard for Mid-Cap stocks, the SPDR S&P MidCap 400 ETF (MDY). Since XMMO also stacks up well against other Mid-Cap ETFs, which are listed later, I give it a Buy rating for gaining exposure to US Mid-Cap stocks.

Invesco S&P MidCap Momentum ETF review

Seeking Alpha describes this ETF as:

The fund invests in momentum stocks of mid-cap companies. It seeks to track the performance of the S&P MidCap 400 Momentum Index. XMMO started in 2005.

Source: Seeking Alpha

XMMO has $1.14b in assets and has a 33bps fee cost. The TTM Yield is just 1.26%.

Index review

Understand the index means understanding the ETF. S&P defines the index as:

The S&P MidCap 400® Momentum is designed to measure the performance of securities in the S&P MidCap 400 universe that exhibit persistence in their relative performance.

Source: S&P Global

They provide these details for how the index is constructed.

They have a Methodology document for those wanting more details.

Holdings review

Here is the sector allocation; more on this later.

The Top 20 holdings account for 43.4% of the portfolio; the smallest 20 out of 76 comes to 13% of the portfolio.

Distribution review

Curious about why the payouts had such large swings, I focused on sector movement, since sectors have varied yields. This is how today’s allocation compares to one year ago.

With the lower allocations in Financials and Real Estate from last summer, I would suspect the reduced payout that XMMO just made might set the pattern going forward. The recent bulge in payments helped with the grade I’m sure, with Seeking Alpha giving the ETF a “B-” grade.

Comparing XMMO to MDY

This section shows how using the momentum factor alters the holdings from the S&P MidCap 400 index. Currently XMMO’s strategy has the portfolio holding a higher weight in Mid-Cap stocks than MDY does. What that also points out is S&P and Vanguard probably do not make the breakpoint between the two classes at the same market-cap level, with Vanguard’s being bigger.

This how the two ETFs overlap and shows XMMO really being a subset of MDY.

While all the sector allocations vary between the two ETFs, XMMO is under-allocated by over 6% in just two: Real Estate and Consumer Discretionary. It is over-allocated by 4% in just Energy.

Morningstar provides the equity factor data, which my marking in green the superior value.

Since XMMO started in 2005, it has had the higher CAGR, but that hasn’t been the case more recently.

Portfolio strategy

As one of the opening charts shows, over the long run Mid-Cap stocks have outperformed both Large-Cap and Small-Cap stocks, though most investors are underweight this part of the market. When looking at various Mid-Cap strategies, Momentum has done the best since 2015; more on that in a bit. Since the Efficient Market Theory (EMT) states that share prices reflect all information and consistent alpha generation is impossible, why does this seem to work. I found several articles on that topic and pick these two I will summarize. As you can tell from the first title, the “why” opinions vary.

• Momentum Investing: It Works, But Why?
• Why Does Momentum Investing Work?

Here are the main points the articles highlight:

• momentum arises because investors underreact to information arriving in small bits, “much like the proverbial frog in a pan that underreacts as the water is slowly brought to boil,”. In short, the EMT has holes.
• momentum stems from classic cognitive dissonance: “Investors react properly to news which confirms their beliefs but underreact to news that disconfirms their beliefs,”.
• momentum works because of natural investor reluctance to sell losers and an eagerness to sell winners (the “disposition effect”) cause share prices to underreact to true fundamental news.
• Some experts believe that confirmation bias can explain outcomes in momentum investing. Another explanation for the high performance of momentum investing in relatively short timeframes is the disposition effect. Most investors are known to feel the pain of losing money more viscerally than the joy of gains.

To me, this quote captures the above points about momentum investing:

Momentum investing is focused more on the short term and involves more volatility. Buying stocks that have momentum also means that you need to trade more capital than with value investing. In addition, buying an underperforming stock that you believe to be undervalued is almost always less expensive than buying a stock that’s on the rise.

Source: Composer

Risk analysis

Since XMMO also stacks up well against other Mid-Cap ETFs, which are listed later, I give it a Buy rating for gaining exposure to US Mid-Cap stocks. There are some who consider the stock market like gambling. If so, you need to know when to fold and walk away with your winnings or before building a bigger loss. Here are a few things that could go wrong owning a Mid-Cap Momentum ETF as compare to other ETFs.

• As we have seen recently, Mid-Cap stocks might start to underperform Large- or Small-Cap stocks. Funds flows in/out effect results.
• Within Mid-Cap stocks, other strategies gain favor and funds flow out of momentum funds into those.
• The big risk is the fact the index only rebalances in March and September, based on data from the prior month-end. Investor sentiment shifts can be missed, though that cuts both ways.

Assuming an investor chose the XMMO ETF over the MDY ETF, the only real risk in owning XMMO is it will underperform MDY.

Final thoughts

Besides momentum, there are other ways to invest in Mid-Cap stocks with their own selection criteria, like earnings, revenue or just equal-weighting the holdings. Here is a list of popular ones amongst Seeking Alpha readers with results back to 2015.

The next chart shows the top ETF is not always the same one over different time frames.

Thanks to a strong year, the Invesco S&P MidCap Quality ETF (XMHQ) is the top performer since 2018; number 2 since 2015. An article on XMHQ is in the works.