Selecting equity investments that have the potential to outpace the overall market is challenging for financial advisors. Based on an analysis by my firm, Tacita Capital Inc. of Toronto, one strategy with the potential to do that is using momentum securities. These are securities that have performed relatively well in the recent past and have the tendency to continue to do so; or, conversely, a relatively poor performer that probably will to continue to lag.

Momentum has been found in a wide variety of assets classes across markets globally. In the U.S., a portfolio of large-cap stocks having positive momentum had an annualized return of 14.2% from January 1927 through December 2012 – far outdistancing the 9.8% return of large-cap stocks in general over the same period.

Of course, momentum stocks do not outperform all of the time. There were 22 periods in which momentum stocks underperformed the broader market by 5% or more, sometimes for as long as several years. The average underperformance was by 11.3% during these periods, so patience is a prerequisite for capturing the benefits of momentum.

Morningstar Canada has developed the Morningstar Canada momentum index (MCMI), tracking 30 highly liquid Canadian common stocks listed on the Toronto Stock Exchange that show both earnings and price momentum as well as above-average returns on assets and equity. From January 2001 through February 2012, the MCMI’s annualized compound rate of return was 14.6% – vs the 5.5% return of the S&P/TSX composite index.

This superior return was achieved with only slightly greater volatility. The annualized standard deviation of the MCMI was 16.7%, vs the S&P/TSX composite index’s 15.7%. Just as important, the maximum drawdown of the MCMI (based on monthend returns) was -37.7% – lower than the -43.3% of the broad market.

Stocks with positive momentum can help to diversify the equities component of a portfolio, particularly one composed of larger-cap value or dividend stocks. The MCMI’s correlation to the Dow Jones select dividend and value indices (0.69 and 0.75, respectively) was lower than its 0.84 correlation with the S&P/TSX composite index. Sectoral limitations contribute to this diversification effect.

The style and size attributes of the MCMI change as its holdings adjust in accordance with the index’s quarterly reconstitution rules. Tacita’s attribution analysis indicates that at certain points, the MCMI is performing primarily like small-, mid- or large-cap growth stocks; at other times, its performance is more akin to small- or mid-cap value stocks. Overall, the style least characterized by the MCMI is large-cap value, as these are the type of stocks least likely to show momentum.

In February 2012,Toronto-based First Asset Investment Management Inc. launched First Asset Morningstar Canada Momentum Index Exchange-Traded Fund (ETF). It’s designed to replicate, to the extent possible, the performance of the MCMI, net of expenses. Similar to most specialized ETFs, its management fee of 0.60% is higher than a broad-market ETF and, unlike an index, faces trading and other costs. The First Asset ETF is off to a promising start, with a shortfall to the MCMI in its first year of only 1.1%. And its 14.5% return easily trumps the S&P/TSX composite index’s 4.6% return.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.

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