Understanding the Quality Factor

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.”

In 2012, Robert Novy-Marx published a pioneering paper that found “a firm’s gross profits (revenues minus cost of goods sold) to its assets” was just as useful for explaining returns as traditional value measures. Eugene Fama and Kenneth French later included profitability in their revised factor model, and Dimensional Fund Advisors (DFA) now includes it along with value and size as one of its key equity strategies.

As other researchers chimed in, the idea of quality has expanded beyond gross profitability. In another influential paper, for example, Clifford Asness and his colleagues at AQR Capital Management defined the quality factor using four measurements: profitability, growth, safety (low volatility, low leverage, stable earnings) and payout ratio. Meanwhile, the index provider MSCI has created a family of Quality Indexes that screen companies based on return on equity, debt-to-equity and earnings variability.

Why have quality stocks outperformed?

As we saw with the low volatility anomaly, it’s difficult to explain quality in terms of reward for greater risk. Why would companies with healthy balance sheets and profitable businesses be perceived as more risky than low quality companies?

“No one can really know exactly why more profitable stocks have outperformed less profitable stocks and whether they will continue to do so with certainty,” writes Jared Kizer of DFA. “Could it be that more profitable stocks earn higher returns because higher profits tend to encourage competitors to enter the same business, and the market is pricing in a return premium for this risk?”

Others have suggested that investors’ appetite for risk can change during a market cycle: they tend to flock to high quality stocks before and during recessions (causing their prices to rise) and then embrace more risk as the economy recovers. But while low quality stocks may thrive during these recoveries, the outperformance is small. On average, the excess return of the high quality stocks during weak markets tends to be greater.

Another school of thought suggests investors will pay more for “headline earnings,” which get a lot of attention, while undervaluing companies with more consistent profitability.

What the critics say

Because there is no agreement on how the quality factor should be defined, any strategy that tries to capture it faces some problems. It’s hard for investors to know which characteristics should be included in an index that targets quality, as not all traditional measures of a company’s strength appear to be useful for explaining stock returns. Unlike value, size, momentum and low volatility, quality has a short history and hasn’t yet endured the scrutiny the other factors have.

It’s also worth pointing out that the authors of some key papers on this factor are associated with investment firms that launched new products almost immediately after the research was published. That doesn’t it mean it should be dismissed, but it warrants an extra layer of skepticism.

How to access the quality factor with ETFs

The granddaddy of quality ETFs is the PowerShares S&P 500 Quality Portfolio (SPHQ), which appeared in 2005. However, that was years before anyone was talking about a quality factor, so the term seems to have been used in a more general sense at first. Indeed, the ETF has  changed its underlying index a couple of times, most recently this past March: it now tracks the S&P 500 Quality Index, which selects 100 large-cap US stocks based on three measures: return on equity, accruals ratio and financial leverage ratio.

Launched in 2013, the iShares Edge MSCI USA Quality Factor (QUAL) is based on the MSCI Quality Index methodology,  which assigns large and mid-cap stocks a score based on return on equity, debt-to-equity and earnings variability. The US version then selects the 125 stocks with the highest score, while the newer international ETF holds about 300 stocks in overseas developed markets.

As we saw with value, the specific method you use to define quality results in very different portfolios. The three largest holdings in SPHQ (Procter & Gamble, Verizon and GE) are nowhere to be found in QUAL, while five of the top six holdings in QUAL are absent from SPHQ.

Two different Canadian ETF providers offer funds based on the MSCI Quality Indexes. Just launched in May, the First Asset MSCI Canada Quality (FQC) is the only ETF that focuses on quality Canadian stocks. It has 25 holdings, the largest of which include CP and CN Railway, Couche Tard and Magna. (Only one bank, CIBC, makes the cut.)

BMO also offers three funds that use the MSCI methodology. The BMO MSCI USA High Quality Index ETF is very similar to QUAL, while the BMO MSCI Europe High Quality (ZEQ) has its largest holdings in the UK, Switzerland and Germany and is hedged to the Canadian dollar. As its name suggests, the BMO MSCI All Country World High Quality (ZGQ) invests globally, though about 65% is currently in US stocks.

WisdomTree, an ETF provider that arrived in Canada in July, offers the WisdomTree U.S. Quality Dividend Growth (DGR), which tracks an index that starts with a universe of dividend growth stocks and then screens for return on equity and return on assets, both of which are associated with profitability. The WisdomTree International Quality Dividend Growth (IQD) uses a similar strategy for stocks outside Canada and the US.

 

Other posts in this series:

Smart Beta ETFs: Your Complete Guide

A Brief History of Smart Beta

Understanding the Value Factor

Understanding the Size Factor

Understanding the Momentum Factor

Understanding the Low Volatility Factor

 

6 Responses to Understanding the Quality Factor

  1. Vin September 29, 2016 at 7:49 pm #

    One simple question, what incremental return are we talking about compared to a typical CCP model portfolio for an annual/regular investment and rebalancing. Let us say for more than 10 years of investment.

  2. John H September 29, 2016 at 9:00 pm #

    Vin, I don’t know the answer to that, but I do know that for the international version, your plain vanilla XAW or VXC will run you 0.22 to 0.27 MER while the BMO all country high quality etf ZGQ goes for 0.51. Which suggests you will need about 0.5% outperformance every year just to cover the added cost…

  3. Canadian Couch Potato September 29, 2016 at 9:18 pm #

    @Vin: Any answer to your question would depend on what specific characteristics you looked at, and of course, you could only look backward. No one can predict whether the outperformance would continue in the future.

  4. Financial Canadian September 30, 2016 at 10:54 am #

    I find it difficult to gauge the “quality” of an ETF given they hold so many constituent stocks. That being said, I know that the CCP model is passive in nature and you guys focus on ETFs. So your approach is sensible given your audience.

    I’m excited to look into the holdings of some of these ETFs and see if they align with my personal portfolio!

  5. Adam October 5, 2016 at 6:33 pm #

    Hi Dan,

    I read through your smart beta blogs and found them very insightful. Who wouldnt want to invest in ETFs that uses formulas crafted from decades of financial analysis.

    I just wanted to clarify a few things.

    1. You kept referring to the Fama-French 5 Factor Model, which consists of beta, value, size, “investment factors”, and profitability. As I read the first few posts, I was under the impression that you were going to analyze each one of these factors, but after the post on size, you branch off to discuss momentum, low volatility and quality. Are these factors captured within “investment factors” and profitability?
    ie. 4th Factor = Investment Factors; Momentum & Low Volatility
    5th Factor = Profitability; Quality

    2. Why was there no ETF recommendations based on beta? After all, it was the first factor recognized by researchers.

    3. It sounds like you put more merit in the principles of small cap and value investing. Do you feel more strongly about these factors then the others?

    For anyone who wanted a rough summary of the ETFs discussed in this series:

    Value
    XCV – Canadian (Cap-Weighted)
    FXM – Canadian (Equal-Weighted)
    VVL – International (CDN, actively managed)
    XXM.B – US Unhedged (CDN)
    VLUE – US
    IUSV – US
    VTV – US
    IVLU – International (USD)
    EFV – International (USD)

    Small Cap
    XCS – Canadian
    XSU – US Hedged (CDN)
    IWM – US
    VB – US
    SCZ – International (USD)
    VSS – International + Emerging Markets (USD)

    Momentum
    WXM – Canadian (Equal-Weighted)
    VMO – International (CDN)
    MTUM – US (CDN)
    IMTM – Non-US (CDN)
    DWG – US (CDN)
    FGL – US + International (CDN)
    HMA – All Markets + Non-equity classes (CDN)
    PDP – US (Equal-Weighted)
    FV – US
    GMOM – US + Non-equity classes

    Low Volatility
    ZLB and ZLU – Canadian
    ZLI – International (CDN)
    PLV – All Markets (CDN)
    XMW – All Markets (CDN)
    VVO – All Markets (CDN, actively managed)

    Quality
    FQC – Canadian
    ZUQ – US (CDN)
    ZEQ – Europe Hedged (CDN)
    ZGQ – All Markets (CDN)
    SPHQ – US
    QUAL – US

  6. Canadian Couch Potato October 5, 2016 at 10:21 pm #

    @Adam: Thanks for the comment, and for your interest in the series.

    1. The Fama-French 5-Factor model is just one of several models that have been proposed. (Other models do include momentum, for example.) The “investment” factor was identified only recently and there are no indexes or ETFs that seek to capture it, so I have chosen to ignore it for now. Profitability, as discussed in this post, is closely related to quality. I hope one of the ideas that has become clear is that the factors are not like chemical elements, where new discoveries are clearly defined and universally accepted. Some are rather vague, and many of them overlap.

    2. Beta, by definition, is the risk of the overall market, so any traditional index fund tracking the broad market is designed to capture beta.

    3. I am pretty agnostic about all of the factors (as I will discuss later in this series) but I think we can agree that value and size have the greatest amount of research to back them up. I actually think value is the one most likely to persist over the long term.

Leave a Reply