JOET vs MTUM & an Understanding of ETF Weightings

The purpose of this idea is two fold. 1) To discuss the fundamental differences between Market-Cap & Equal-Weighted ETFs & 2) To compare JOET & MTUM ETFs. The first half will cover topics specific to ETFs. The second half and very last section offers a comparison of the funds and conclusions to consider when choosing one. Feel free to skip to the bottom if the analysis or conclusions related to the ETFs is all that you wish to read.

Definitions

• Market Capitalization = (stock price * outstanding shares)
  
• Momentum is the speed or velocity of price changes in a stock, security, or tradable instrument. Momentum indicates a stock’s price strength. (Source: Investopedia)

Market Cap Weighted Indices

Mechanics
In market cap weighted indices, price plays a key role of weight. Asset allocation goes to stocks with rising prices over time, while allocation to stocks with decreasing prices, becomes smaller.

Behavior

• Inherently momentum oriented.
  
• Concentrated on the winners.
  
• Anti-value like dynamic when weighting toward market cap.
  
• Performs the strongest in a growth based market or when you have concentration in some sectors or stocks but not others.
  
• Conversely, concentration risk is realized if a stock or sector’s market cap becomes concentrated regardless of actual growth and then crashes (eg. 2000 dotcom bubble).

Equal-Weight Indices

Mechanics
In Equal-Weight indices, allocation is spread evenly across all stocks and regularly rebalanced at a predetermined time interval.

Rebalancing

• Stocks in an index which have increased from equal weight average will be in excess of the average weight. The excess (difference between the new price and the price at the average weight) is sold.
  
• Stocks which have decreased from the last rebalancing will be below the average weight and the difference is bought. This mechanism ensures all stocks share an equal weight at the time of rebalancing.
  
• Because rebalancing typically occurs at predetermined time intervals (often quarterly), there will usually be a degree of asset allocation unbalance between those intervals, as stocks go up and down. Rebalancing daily isn’t practical and would lead to higher management costs.

Behavior

• Broader exposure to the overall market.
  
• Favors value stocks and smaller sized companies.
  
• Protects against concentrated risk in a few stocks that may dominate a market cap weighted index.
  
• Performs the strongest when there is broader market participation and when smaller size / value stocks are in favor.

Costs
Equal weighted ETFs have higher turnover from rebalancing weighting = higher fees and higher capital gains taxes

Market Cap & Equal-Weighted (MISC)

Both Equal and Market Cap weighted ETFs require reconstitution or adjustments of their holdings as stocks fall in or out of their parameters of measurement. Examples could be: mergers, delistings, or new inclusions from the parent or underlying index the fund is tracking.

---

MSCI USA Momentum Factor ETF - MTUM

Dividend Yield: 1.01%
Expense Ratio: 0.15%

Hierarchy
MSCI USA Index (Parent Index)
MSCI USA Momentum SR Varient Index (Underlying Index*)
MSCI USA Momentum Factor ETF (The Fund / MTUM)
*On November 23, 2020, the Fund’s Underlying Index changed from MSCI USA Momentum Index to the MSCI USA Momentum SR Variant Index

Prospectus notes
“ uses a representative sampling indexing strategy to manage the Fund. “Representative sampling” is an indexing strategy that involves investing in a representative sample of securities that collectively has an investment profile similar to that of an applicable underlying index.”

“The Underlying Index is designed to measure the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover....”

“The Fund generally will invest at least 90% of its assets in the component securities of the Underlying Index and may invest up to 10% of its assets in certain futures, options and swap contracts, cash and cash equivalents, including shares of money market funds advised by BFA or its affiliates, as well as in securities not included in the Underlying Index”

How does MTUM determine the makeup of a “Momentum” stock?
The exact calculation is not published but, MTUM screens for the best performing US Large and Mid-cap stock price returns over the past three years, 12 months, & 6 months as a factor for inclusion into the fund.

What is MTUM’s reconstitution strategy when adding / removing stocks from the fund?

MTUM cites using a statistical model published in the Journal of Finance:

N. Jegadeesh and S. Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 1993.

The research suggests, buying past winners and selling past losers, you can achieve profitable returns.

Thesis of the model:

• Buy past winners and sell past losers in multiple time configurations. (only two configurations are selected in practice)
  Winners measured over 12, 6, 3, or 1 months prior to the time of purchase.
  
• Top winners are selected (selected stocks).
  
• Performance of selected stocks are measured over 12, 6, 3, or 1 months after the time of purchase.
  
• Winners & losers are selected.
  
• Buying more of the winners and selling the losers occurs.
  
• Takes advantage of short term market inefficiencies and lag time between corporate events and price movements. Eg. earnings announcements.

The research conducted demonstrates buying winners and selling losers works within a 12 month timeframe. Beyond 12 months the strategy breaks down.

Because MTUM reconstitutes the fund semi-annually and profitability using this strategy occurs within a 12 month period of time, the fund should be able to realize similar profitable outcomes.

Virtus Terranova U.S. Quality Momentum ETF - JOET

Dividend Yield: Dividends reinvested
Expense Ratio: 0.29%

Hierarchy:
Terranova U.S. Quality Momentum Index (Underlying Index)
Virtus Terranova U.S. Quality Momentum ETF (The Fund / JOET)

How does JOET determine the makeup of a “Momentum” stock and the ETF?

• Screens 500 US large cap stocks for the last 12 months’ total return (technical indicator)
  
• 500 then ranked based on momentum and quality
  
• Momentum is ranked based on the last 12 months’ total return
  
• Quality is ranked based on:
  
• return on equity (net income divided by average shareholder equity)
  
• debt to equity (total liabilities divided by total shareholder equity)
  
• sales growth rate (annualized sales growth rate over the past three years).
  
• Pick top 250
  
• The 250 Stocks are then again quality ranked based on the same metrics above.
  
• Top 125 chosen for the inclusion into the Underlying Index and used in the fund.
  
• Equal weighted / rebalanced quarterly
  
  What is JOET’s reconstitution strategy when adding / removing stocks from the fund?
  Their strategy mimics the above, rebalanced & reconstituted quarterly.
  
  ---
  
  Factors to consider when selecting JOET vs MTUM
  
• Costs of ownership / fees / dividend yield -- JOET is nearly 2x more expensive than MTUM, excluding any dividend yield. MTUM’s ~1% dividend yield is also a consideration when selecting.
  
• Stock Selection -- MTUM uses a more technical approach to stock picking, rebalancing, and reconstitution. JOET uses a combination of both technical and fundamental (quality) indicators when stock picking, rebalancing, and reconstitution.
  
• Timeframe & Concentration Risk -- With concentration risk in MTUM’s market cap weighted fund, you must consider the forward 12 month performance for the sectors most heavily weighted. Historical data shows equally weighted outperform market cap weighted indices (there are exceptions by sector). Equally weighted indices do a better job of mitigating single-stock event risks. If a stock takes a header during an earnings announcement, the impact on the fund will be lower if in an equally weighted fund.
  
• Sector weighting inside the funds -- JOET & MTUM stock selection begins with the largest US market cap weighted stocks. JOET holdings are equal-weighted, but not the sectors that make it up. JOET is made up of ~33% Tech & ~22% Healthcare stocks.
  4 of the top 5 weighted sectors make up the majority of both funds.
  
  Conclusion / Determination
  
  This mostly boils down to deciding which fund does a better job of stock picking.
  
  JOET & MTUM use different stock selection techniques for inclusion into their respective funds, however, both utilize market cap weighted indices when making initial stock selections, leading to similarly skewed sector weighting in both funds (particularly Tech & Healthcare). Although, while sector weighting is concentrated similarly in both, the underlying holdings making up those sectors are largely different. Of the roughly 125 stocks in each ETF, only 48 names are shared in both ETFs.
  
  If you believe a more technical stock picking process, weighting, rebalancing, and reconstitution strategies will work better, MTUM is the winner. MTUM does carry a higher degree of concentration or single-stock event risk and is not as diversified across sector allocation vs. JOET. However, during times when market cap leaders are leading, MTUM will outperform.
  
  If you believe a combination of technical and fundamental quality factors for stock picking & reconstitution strategies will work better, JOET is the winner. JOET is more expensive to own with a higher expense ratio. However, by nature of being equal-weighted, longer term hold durations should have stronger positive outcomes, and lend credence to value-like holdings that have not yet surprised to the upside. JOET also provides exposure to what Virtus believes are higher quality stocks with stronger fundamentals, as that is a criteria for their selections.
  
  Because JOET is less than 12 months old, historical performance cannot be compared with MTUM’s. Additionally, because MTUM recently changed the underlying index used for stock selection and inclusion into the fund (Nov 2020), its historical performance cannot be used as an indicator or expectation of how the fund may perform moving forward.