Why Does ETF Momentum Work?

by Will Gish

Exchange-traded funds (ETFs) are a type of commodity sold on the stock exchange. As with most publicly traded commodities, EFTs are subject to frequent fluctuations in both value and momentum. Determining whether ETF momentum works and, if so, why requires a brief look at the nature of ETFs, an understanding of momentum and a grasp of how and why these two affect one another. Ultimately, ETF momentum may only work conditionally.

ETFs and Momentum

Exchange-traded funds are mutual funds traded on public markets as stocks, hence the name "exchange-traded" (meaning traded on a stock exchange) and "funds" (as in mutual funds). The success of ETFs after their introduction in the early 1990's led to an explosion of these funds, which currently trade on national and regional markets in a variety of sectors including technology, energy, micro-cap stocks, large-cap stocks and utilities. Momentum occurs in commodities trading, and on the stock market generally, when an investment opportunity increases its value rapidly or steadily over a compressed time, usually three months or less. Trading on stock momentum involves speculation and attempts to predict and time market trends.

ETF Momentum

ETF momentum occurs when an exchange-traded fund experiences rapid growth in the short term. Indefinite momentum is impossible to sustain because every ETF fund eventually reaches a point at which it can no longer generate sufficient profits to justify investment and bursts. ETF momentum traders often agree to future deals. For instance, a trader may expect momentum in an ETF and create an option to buy a certain number of shares at the current rate of $50 in three months. If, in three months, the momentum of the ETF has raised the value of a share from $50 to $75, the buyer purchases the shares and sells them immediately for a $25 profit per share. If the momentum falters and stock prices remain the same or fall, the buyer lets the option expire. Buying into ETFs during momentum rather than creating future options substantially increases investment risks.

Why ETF Momentum Works

The question of why ETF momentum works is based on the presumption that ETF momentum does work. For many traders, ETF momentum, and momentum in general, leads to enormous losses, so this trading strategy doesn't work at all. Successful ETF investors make ETF momentum work profitably by entering the momentum swing at the right time (before the upward peak) and exiting at the right time (before the passing of the upward peak). In emerging markets, ETFs invested in sectors like materials and technology gain momentum because the economy needs these assets. In this sense, ETF momentum works because of market demand. In the most basic and abstract sense, ETF momentum works because market trends lead to fluctuations in the value of commodities, which precipitates increasing and decreasing momentum in an ebb-and-flow pattern.

How ETF Momentum Works

ETF momentum works on a short time span. Assume that the lifespan of an ETF momentum upswing and downswing resembles a hill. Walking over this hill takes a few months. Investors seeking to maximize profits on an ETF get in on the stock as it begins moving upward and get out before it hits the same point of value going down. EFTs, and commodities in general, cannot sustain constant raises in value over long periods of time, making momentum an inherently short-term phenomenon. Furthermore, when too many investors buy in on a momentum commodity, they over-saturate the market with shares, making it impossible for all of them to sell at a profit as the momentum on the commodity declines.

Momentum vs. Long-Term Gains

Short-term trading involves a high degree of financial risk and often proves to be an abject failure. According to a fact sheet published by the McGladrey & Pullen CPAs, momentum trading has proven to be a trading trend that many now accept as an inefficient method of investment. A variety of factors, such as events, political decisions and market trends, affect momentum but often not the long-term value of a commodity. Momentum may raise and lower the value of an ETF stock a great deal in the short term, but over the longer term, these fluctuations prove irrelevant if a stock shows a good return.

Photo Credits

  • Comstock/Comstock/Getty Images