2 Vanguard ETFs Beating the S&P 500 With a Momentum-Driven Strategy

Momentum investing -- the general idea that you should let your winners run -- is a popular strategy on Wall Street. In fact, multiple studies, including the well-known Eugene Fama and Kenneth French study, have found that there is the potential to capture higher returns by following a momentum strategy.

Vanguard is much more well-known for its lineup of broad, ultra-low-fee index funds, but it does actually have a pair of ETFs that incorporate the momentum factor into their strategies. They fly under the radar because they don't necessarily fit the Vanguard stereotype. But they've been around for more than eight years, and they have a solid track record of beating the S&P 500.

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What a momentum ETF should look like

A good momentum strategy follows a well-documented rules-based structure. A lot of the results will depend on the time frames used as part of its lookback period. Most will use somewhere between three and 12 months. Some will use multiple lookback points (such as three months and six months). Either strategy can work, but it generally shouldn't look at periods longer than 12 months.

A scored weighting approach, or one that gives higher weightings to those stocks demonstrating stronger momentum, also tends to work better. Market cap-weighted approaches emphasize company size over the momentum factor, which usually diminishes effectiveness. The two Vanguard ETFs meet both of these criteria.

Two Vanguard ETFs that beat the S&P 500

Vanguard U.S. Momentum Factor ETF

The Vanguard U.S. Momentum Factor ETF (NYSEMKT: VFMO) is a pure momentum-based stock picking strategy. It starts with a universe of U.S. stocks of all sizes and looks at returns over the prior six-month and 11-month measurement periods.

Stocks with greater momentum scores receive higher weightings in the portfolio. But given that there are more than 700 stocks in the ETF, diversification is high and concentration across any sector or market capitalization is low.

Vanguard U.S. Multifactor ETF

The Vanguard U.S. Multifactor ETF (NYSEMKT: VFMF) defines momentum in the same way that the Momentum ETF does, but it's just one of four factors that are considered together: momentum, quality, value, and low volatility.

This ETF is similarly diversified, and components are weighted using a composite factor score. Because it considers some more traditionally defensive metrics in its selection process, it tends to have lower volatility than a pure momentum strategy.

Data source: Vanguard.

The most obvious takeaway here is that these two momentum-based ETFs look nothing like the Vanguard S&P 500 ETF. The S&P 500 is much more heavily concentrated in a handful of mega-cap tech companies. The tech sector itself accounts for nearly 40% of the portfolio, one of the highest sector concentrations the index has ever seen.

The other two ETFs have no such individual component concentration issues. Even at the sector level, investments are spread out much more uniformly among a combination of growth, defensive, and cyclical sectors. This is one of the earmarks of a solid momentum strategy. It focuses on individual stock momentum, regardless of where it's coming from. Plus, more than half of each ETF is invested in mid- and small-cap stocks, providing true diversification benefits when paired with an S&P 500 fund.

The historical returns, however, tell the story. Both Vanguard ETFs have outperformed the S&P 500 year to date and over the past one-, three-, and five-year periods. The fact that they've done this without the tech or large-cap concentration is even more impressive. Vanguard's factor ETF lineup doesn't get the credit it deserves, but its momentum factor strategy has definitely demonstrated its worth over time.

David Dierking has positions in Apple. The Motley Fool has positions in and recommends Advanced Micro Devices, Alphabet, Apple, Applied Materials, Micron Technology, Nvidia, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.