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Momentum Vs. Laggard Investing: Why Not Both?

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First devise an allocation strategy, then consider these ETFs to make your plays.

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There are decisions to be made between momentum or bottom-fishing investing, also known as laggard investing. The reality is that an investor can do both; he or she can invest in the market favorites, which is momentum investing, and also invest in laggards, which is bottom fishing. Bottom fishing is also known as buying fallen angels, which are asset classes that are out of favor. One asset class has poor momentum and the other has good momentum. But investing in just one of the asset classes could be a problem: You are making an all-out bet that the good momentum group will continue and/or the poor momentum group will turn.

Exacerbating the problem of all-or-nothing momentum investing is the way that markets move. In my book Winning with ETF Strategies (Minyanville/FT Press 2012), the Birinyi study shows what returns you would have gotten if you had been out of the market on the worst five days each year, if you had been out of the market on the best five days each year, and if you had simply held the S&P 500 (INDEXSP:.INX) through the good days and the bad days of each year. The results show that if you are out of the market on the best days, your performance will suffer -- and one never knows when the good days will be. So it is best to be in the market. If you are net long almost all of the time, which seems to be a good strategy, it is a higher risk strategy to just pick one momentum asset class subset to invest in.

Generally I prefer to invest in laggards if the fundamentals look alright. If I'm right on the valuations, the future investment probabilities, and the overall economic outlook, the trade will be profitable. It might take a while because it takes time for laggards to turn.

Others like momentum plays, which is buying the hot groups. I've been burned too many times to invest that way. When groups are hot and making new highs, and everybody's piling in, it's too late in the game for me.

According to how you want to invest, you will have to devise an allocation strategy. For instance, you could have perhaps 20% laggards at certain times and 40% laggards at other times. The biggest factor is your risk appetite. Momentum asset classes often, but not always, have more risk than laggard asset classes. Often lower multiple classes are less risky than higher multiple classes.

A Momentum ETF

If you want to invest in momentum, consider the social media class. Social media stocks such as LinkedIn (NYSE:LNKD), Groupon (NASDAQ:GRPN), and Facebook (NASDAQ:FB) have been leading the market and have turned into the momentum players' favorite trading and investing names. Many social media stocks have characteristics that are typical of momentum stocks, in that they have high multiples, if they have any earnings at all.

Global X Social Media Index ETF (NASDAQ:SOCL) offers exposure to many of the well-known social media stocks. Its holdings include LinkedIn, Facebook, SINA Corporation (NASDAQ:SINA), Tencent Holdings (HKG:0700), and other social media favorites. Certainly SOCL is a momentum security, and like other momentum asset classes that are still young from an earnings standpoint, somewhat like biotech and genome companies as well as alternate energy companies, the companies are expected to produce stellar earnings, but have yet to do so. The multiple of SOCL is 32 times, which means that the stocks in the ETF have been bidden up, and the stocks are selling at higher multiples, which identifies SOCL as a momentum play.

A Laggard ETF

Recently there has been a wide divergence between investors not favoring emerging markets and the potential economic realities of the post-Lehman crisis world economies. Global investors are mostly significantly underweighting emerging markets relative to developed countries, both in North America and Europe. This underweighting creates a potential opportunity for investors, since merely bringing weightings back up to pre-crises levels could lift the emerging markets asset class. In the pre-crisis times, it was common to hear that emerging markets should comprise about 30% of a portfolio. You seldom hear that anymore since investors think it should be a much lower allocation.

The most compelling part of the emerging market investing outlook is the increase in the middle class. With a growing middle class, there is sustainable growth, more than with merely an export growth economy. This is true in all of the emerging markets countries, including China. The Brookings Institution reports that China's middle class is the second largest in the world in absolute terms, at 157 million consumers. The US is first. Still, the China middle class is small in relative terms, comprising on 12% of the population. By 2020, most of China's population could belong to the middle class, consuming nearly $10 trillion in goods and services.

The middle class growth in emerging markets scenario includes the economics that go into a country's reduction of poverty. A country's internal consumer market usually improves when people move from poverty into the middle class. This increased consumption includes food and shelter and expands out into consumer durables and services. For instance, although China is experiencing difficulties in housing and other areas of its economy, its estimated GDP is still higher than most developed countries. If China can continue its growth, housing, autos, and consumer durable goods will benefit.

For exposure to a speculative but low-multiple ETF in the emerging market space, consider the Guggenheim Small-Cap China ETF (NYSEARCA:HAO). HAO is volatile, having lost about 50% over the last two years, but that is after gaining about 120% from the lows attained during the Lehman crash lows. Investors have to be patient with HAO, and the security has risk. HAO replicates an index created by AlphaShares and is constructed to include small-cap mainland China based publicly traded companies. To be included into the index, a company must have a capitalization of at least $200 million and under $1.5 billion. HAO sells at about 10 times earnings, which is reasonable. The major sectors in the ETF are industrials, financials, and consumer discretionary, and it allow a good exposure to the internal growth of China.

Editor's Note: Max Isaacman is the author of Blizzard of Money, Winning with ETF Strategies, Investing with Intelligent ETFs, How to Be an Index Investor, and The NASDAQ Investor.
Max Isaacman and/or his clients hold HAO.
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