This is Part 7 in a series about smart beta ETFs. See below for links to other posts in the series. In this installment, we look at the quality factor: the idea that companies with strong balance sheets and profitable businesses tend to outperform.
So far in this series we’ve looked at value, size, momentum and low volatility as factors linked to higher returns over time. The final factor we’ll examine is the newest and the most nebulous. There are several definitions of the quality factor, though all of them are associated with durable and sustainable companies with competitive advantages, strong balance sheets, stable earnings and high margins.
While it might seem obvious that such companies would deliver higher returns, that’s not how efficient markets are supposed to work. A company’s higher quality should be reflected in a higher stock price, and expensive stocks aren’t supposed to outperform: that’s why there is a value premium, after all. As Larry Swedroe explains, this surprising factor “is based on quality characteristics irrespective of stock prices, while a value strategy is based on stock prices irrespective of quality.”