You Can Lower Your Risk With This Momentum-Stock Fund. It Has Outperformed the S&P 500

Building a diversified investment portfolio using exchange-traded funds (ETFs) can be achieved by selecting funds based on geography, company size, or investment strategy. Including a momentum-based fund can complement a traditional index fund by potentially delivering higher returns through both bear and bull markets.

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A key consideration in portfolio diversification is market concentration. Broad market indices, like the S&P 500, are typically weighted by market capitalization. This can lead to significant concentration in a few major companies. Currently, the "Magnificent Seven" — Apple, Nvidia, Microsoft, Amazon, Alphabet (including both share classes), Meta, and Tesla — account for 32% of the SPDR S&P 500 ETF Trust (SPY), with the top three holdings making up 19.6% of the fund.

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In comparison, the Invesco S&P 500 Momentum ETF (SPMO), valued at $5.6 billion, holds only three of these seven companies—Amazon, Nvidia, and Meta—which collectively represent 26% of its 100-stock portfolio. While this fund is less exposed to the Magnificent Seven overall, it remains highly concentrated at the top.

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The Invesco S&P 500 Momentum ETF follows a momentum-based strategy, reconstituting its portfolio twice annually on the third Fridays of March and December. Stocks are selected based on their price performance over the previous 12 months, excluding the most recent month, and adjusted for volatility. The top 20% of S&P 500 companies based on these scores are included in the fund, with holdings weighted by a combination of momentum score and market capitalization.

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Although this momentum strategy may appear aggressive due to its focus on recent winners, the semi-annual rebalancing allows the fund to exit underperforming stocks. According to Nick Kalivas, Invesco’s head of factor and core ETF strategy, this systematic approach helps manage risk by providing a mechanism to remove companies facing fundamental weaknesses.

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Kalivas highlighted the dynamic nature of the fund’s exposure to the Magnificent Seven, which accounted for 40% of the fund’s holdings in 2021, dropped to zero in 2022 and early 2023, and then returned to 40% by March 2024. This flexibility allows the fund to adapt to changing market conditions.

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Since adopting its current strategy in June 2019, the Invesco S&P 500 Momentum ETF has demonstrated distinct performance characteristics compared to the S&P 500. During the broad market decline in 2022, led by tech-heavy losses like Tesla’s 65% drop, the fund mitigated a significant portion of the S&P 500’s losses. While it lagged behind the index during the 2023 recovery, it outpaced the broader market as the bull run extended into 2024.

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A comparison of returns from the end of 2021 through early 2024 illustrates how the fund’s momentum-driven approach has differentiated its performance. This ability to adjust holdings helps the fund capitalize on market trends while reducing exposure to declining stocks.

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As of late February 2024, the fund’s top holdings reflect a mix of leading technology and consumer companies. Amazon represents 9.8% of the portfolio with a 21.6% one-year return, Nvidia accounts for 9.1% with a 65.3% return, and Meta holds 7.2% with a 38.4% gain. Other significant positions include Broadcom, Berkshire Hathaway, Eli Lilly, JPMorgan Chase, Costco, Walmart, and GE Aerospace, each contributing between 2.2% and 6.8% of the fund.

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Beyond large-cap stocks, Invesco also offers momentum ETFs focused on mid-cap and small-cap companies. The Invesco S&P MidCap Momentum ETF (XMMO) and the Invesco S&P SmallCap Momentum ETF (XSMO) apply a similar strategy to the S&P MidCap 400 and S&P SmallCap 600 indices, respectively.

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Over the three years ending in 2024, both mid-cap and small-cap momentum ETFs outperformed their respective indices. The Invesco S&P MidCap Momentum ETF delivered a 39.5% return, surpassing the S&P MidCap 400’s 19.8% gain. Similarly, the Invesco S&P SmallCap Momentum ETF achieved a 20.7% return compared to 8.9% for the S&P SmallCap 600.

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The greater volatility and reduced concentration of mid- and small-cap indices explain their steeper losses during 2022. However, both momentum ETFs rebounded strongly in the following years, benefiting from their ability to capture emerging trends.

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Kalivas emphasized that momentum investing can adapt to market shifts, citing artificial intelligence and weight-loss drugs as recent examples of dominant themes. This adaptability allows the strategy to exit underperforming companies over time, unlike the S&P 500, which remains tied to its market-cap-weighted structure.

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Incorporating a momentum ETF alongside a traditional index fund can enhance portfolio diversification. According to Kalivas, “Momentum is the life of the party. It shows up late and tends to stay too long, but during the middle of a trend, it can generate significant returns.” This approach offers investors a differentiated return profile while maintaining exposure to evolving market leaders.

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