JOET: Flawed Screens Doom This Quality Momentum ETF (NASDAQ:JOET)

Investment Thesis

When rules-based ETFs reconstitute during volatile periods, they risk deleting poor-performing securities as they bottom, and not adding them back until after their prices recover. I call it the turnover trap, and even top-performing ETFs I’ve studied are victims. Unfortunately, the Virtus Terranova U.S. Quality Momentum ETF (NASDAQ:JOET) will be no different. Technology stocks have sharply fallen this year, yet JOET still maintains a 20% allocation to the sector. If my calculations are correct, expect that exposure to be cut in half next quarter as its 12-month momentum screen rolls over. However, that’s precisely the opposite of how you should treat high-quality stocks, and for that reason, I recommend investors avoid JOET.

ETF Overview

Strategy and Fund Basics

JOET tracks the Terranova U.S. Quality Momentum Index, selecting 125 large-cap U.S. stocks for momentum and quality factors. The selection process begins with the 500 largest U.S. stocks, then cuts the list in half to 250 based on 12-month total returns. It’s further reduced to 125 based on a composite score resulting from three quality screens: return on equity, debt-to-equity, and three-year annualized sales growth. In a previous article, I wrote how separating price momentum from at least two of these screens is not easy. The debt-to-equity is the unique factor here since companies experiencing high price momentum usually have solid sales growth and profits.

The Index reconstitutes and rebalances quarterly to an equal weight, which is very aggressive and dangerous during volatile times. My research indicates the momentum factor works well in steady markets. However, in volatile markets, an anti-momentum strategy works best. In other words, investors should buy the most beaten-down securities, so long as they’re of high quality. For me, it’s a critical flaw and why JOET will likely underperform.

Before we get to JOET’s exposures, I’ve listed some additional information below for your reference.

• Current Price: $26.43
• Assets Under Management: $83 million
• Expense Ratio: 0.29%
• Launch Date: November 17, 2020
• Trailing Dividend Yield: 0.53%
• Five-Year Beta (Current Portfolio): 1.02
• Number of Securities: 125
• Portfolio Turnover: 59% (For Six-Month Period Ending January 31, 2022)
• Assets in Top Ten: 9.56%
• 30-Day Median Bid-Ask Spread: 0.12%
• Tracked Index: Terranova U.S. Quality Momentum Index

The fund is well-established, with $83 million in assets under management. Its 0.29% expense ratio is moderate, though its 0.12% bid-ask spread is elevated for large-cap stocks. Add this to the cost of trading if you plan to jump in and out of the fund regularly.

Sector Exposures and Top Ten Holdings

JOET’s sector exposures are listed below. I’ve also provided exposures for the SPDR S&P 500 ETF (SPY), the Invesco S&P 500 Momentum ETF (SPMO), and the Invesco S&P 500 Quality ETF (SPHQ). Since JOET aims to combine fundamental analysis through quality screens and technical analysis through price momentum, I think these are reasonable comparators.

Technology and Health Care account for over 20% each, while Financials and Industrials have 17.78% and 11.60% allocations. Note how there is virtually zero exposure to the Utilities sector for JOET, SPMO, and SPHQ. I find this troubling, as large-cap Utilities are excellent quality and act as insurance during downturns. The Utilities Select Sector SPDR ETF (XLU) is the second-best-performing large-cap sector ETF this year, and it’s another example of rules-based ETFs being slow to react in volatile markets.

Although Technology accounts for over 20% of the ETF, the only one in the top ten is Analog Devices (ADI), a semiconductor company that’s held up remarkably well in the tech selloff. Most of the other 25 technology stocks are near the bottom of the holdings list and could be overlooked. However, remember that it’s an equal weight ETF and the bottom holdings merely represent the worst-performers since the last rebalancing.

Performance Analysis

JOET’s historical performance is limited, but it hasn’t lived up to its objective of combining the benefits of momentum and quality. With higher volatility, it’s underperformed SPMO and SPHQ by an annualized 1.86% and 4.37%.

Against other momentum and quality ETFs, JOET also performed relatively poorly. Here are periodic returns for 17 peers plus SPY, along with the five-year betas of their current holdings.

I’ve sorted returns according to their one-year trailing returns, and JOET placed about average. The two-best performers are large-cap dividend ETFs with low price-earnings ratios and less susceptibility to negative sentiment changes. After a couple of years of abnormally high earnings surprises, company valuations are a closely watched metric again, and, unfortunately, it’s not a screen in JOET’s Index.

Criticism Of Screening Process

While valuation is worth considering, JOET’s most significant problem is the timing of its trades caused by its 12-month momentum screen. When designing the Index, I assume its creator envisioned it to be incredibly responsive to markets, which is why it reconstitutes quarterly. However, a three- or six-month momentum screen is preferable if this was the objective. That’s why Technology is still 20% of the ETF even though the Technology Select Sector SPDR ETF (XLK) is down 23.15% this year, the third-worst performer. If securities were screened using a shorter time frame, the Index would likely be overweight Energy and Utilities, and JOET would have joined several high-dividend ETFs as a top performer this year.

I decided to simulate what I think JOET’s sector exposures will be in three months. I noticed that nearly all current holdings have a Seeking Alpha Profitability Grade of B+. I’ll use that as an overall quality screen and apply it to S&P 500 companies, assuming that returns are flat until then. Obviously, that’s unrealistic, but I don’t want to disadvantage any particular sector. So, let’s walk through the two-step selection process in more detail. The following graph highlights the number of S&P 500 stocks in each sector and the number of stocks that passed the momentum and profitability screens.

First, notice how there are 75 technology stocks in the S&P 500, but only 21 Energy stocks. Naturally, this creates an unfair bias and, in my view, is a fatal flaw. The Index’s creators missed that most of a portfolio’s excess returns are driven by sector allocation decisions (asset allocation effect) rather than stock-picking within each sector (stock selection effect). They’ve designed an Index that requires Technology stocks to perform terribly before exposure is meaningfully lowered. Ironically, significant declines in such high-quality companies would probably warrant a buy decision instead.

Furthermore, if quality is akin to profitability, I’ve estimated that 15/75 Technology stocks will still qualify in three months. However, only 12/21 Energy stocks will. Technology will have more representation despite Energy outperforming by 78.09% YTD. It makes no sense. A better way would be to constrain each sector’s weights based on short-term performance (i.e., 3-6 months) and then select the best-quality stocks in each sector.

Finally, it looks like Utilities stocks don’t have a chance despite their recent outperformance. Only five qualify, and that’s because of the average B- Profitability Rating for S&P 500 stocks in that sector. Examples are Atmos Energy (ATO) and Edison International (EIX), each up around 20% in the last year. However, both have negative EPS growth over the previous twelve months, earning them Profitability Grades of F and D.

Investment Recommendation

JOET attempts to combine fundamental and technical analysis, but goes about it badly. In volatile markets, a 12-month momentum screen will be too slow to react and will likely result in the Index selling underperformers too late and buying outperformers at peak prices. Furthermore, by assessing momentum at the individual security level rather than at the sector level, the Index creators demonstrate overconfidence that’s not warranted. Most alpha is generated by overweighting the right sectors, rather than picking the best stocks within each sector. In my view, the screening process should start there.

To conclude, don’t buy JOET, and if you already hold it, consider switching to one of the alternatives I listed earlier. I think SPMO and the Global X S&P 500 Quality Dividend ETF (QDIV) are good choices today, and if you would like more information on these funds, please feel free to ask below. Thanks for reading.