The momentum trade has taken a painful hit in recent weeks, but Morgan Stanley believes the worst may be over. This view could put momentum-focused ETFs back on investors' radar.

Michael Wilson, the bank's chief U.S. equity strategist, said one of the "worst momentum selloffs in history" is giving way to a healthier market environment where leadership is rotating away from semiconductor stocks and toward companies with stable earnings, stronger margins and better operational efficiency. Rather than signaling the end of the momentum factor, Wilson argues the selloff represents a reset as investors shift to a new group of market leaders.

The comments, highlighted by Bloomberg, come after a Goldman Sachs basket of momentum stocks plunged 35% from its June peak, underscoring how quickly investors unwound crowded positions in AI and semiconductor names. Even so, the basket remains up 9.4% for the year, roughly in line with the S&P 500.

Why Momentum ETFs Were Hit

Momentum ETFs generally track stocks with the strongest recent price performance, periodically rebalancing to capture market leadership. During the AI-fueled rally, many of these funds accumulated significant positions in semiconductor and mega-cap technology companies, leaving them vulnerable when investors began taking profits amid concerns over soaring AI infrastructure spending.

The pullback was particularly severe across chip stocks, which had been among the biggest beneficiaries of the artificial intelligence boom. As chip stocks corrected, many momentum strategies suffered sharp declines alongside them.

ETFs to Watch

The largest and most closely followed momentum ETF is iShares MSCI USA Momentum Factor ETF (BATS:MTUM). The fund has lost almost 9% of its value in the past month.

With $25 billion in assets under management, MTUM tracks the MSCI USA Momentum Index and rebalances semiannually, selecting U.S. large- and mid-cap stocks with the strongest risk-adjusted price momentum. Because of its rules-based approach, the fund naturally increases exposure to market leaders and trims positions in laggards over time.

The recent correction likely reduced the value of MTUM's technology holdings, but Wilson's thesis suggests the ETF could benefit if momentum simply shifts toward sectors posting consistent earnings growth rather than disappearing altogether. As the index rebalances, the portfolio may gradually tilt toward industries such as healthcare, insurance and other quality-oriented businesses.

Another fund in the space is Invesco Dorsey Wright Momentum ETF (NASDAQ:PDP), which follows the Dorsey Wright Technical Leaders Index. Unlike MTUM, PDP relies more heavily on relative strength rankings and often carries different sector allocations, making it another way for investors seeking exposure to a recovering momentum factor. The fund is down more than 7% in the past month.

Investors looking beyond large caps may also consider Invesco S&P MidCap Momentum ETF (NYSE:XMMO) and Invesco S&P SmallCap Momentum ETF (NYSE:XSMO), which apply momentum screens to mid- and small-cap stocks. If market leadership broadens beyond mega-cap technology, as several Wall Street strategists expect, these funds could stand to benefit from improving participation across the broader market.

Momentum Is Evolving, Not Dying

Wilson's outlook suggests investors should distinguish between a collapse in the momentum factor and a rotation within it. As the economic cycle matures, he expects companies with stable earnings histories to increasingly dominate momentum rankings, replacing some of the higher-beta AI beneficiaries that led markets over the past year.

That view is echoed elsewhere on Wall Street.

Goldman Sachs strategist Ben Snider said the recent AI consolidation resembles previous momentum pullbacks and noted that investor deleveraging could improve the setup for another advance if earnings remain supportive, according to Bloomberg.

What It Means for ETF Investors

For ETF investors, the recent selloff may represent an opportunity to reassess them.

Momentum ETFs automatically adjust to changing market leadership. If higher-quality sectors begin to outperform, the funds will gradually rotate into those names.

S&P 500 companies are enjoying one of the strongest earnings seasons in years, with 86% beating estimates, according to Bloomberg Intelligence. If earnings strength broadens beyond AI and semiconductor stocks, momentum ETFs could find fresh drivers for gains.

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