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By Samuel Lee

"Quality" is one of those slippery investment terms. Who doesn't love high-quality companies, of course run by able managers and bought at low prices? I admit I've added to the confusion by using the word inconsistently or imprecisely myself. At its worst, quality simply becomes indistinguishable from "good." The most logical and useful definition I know of is Warren Buffett's concept of the economic moat, a durable competitive advantage that allows a firm to reap above-average returns on its capital even when faced with aggressive competitors. Quality stocks have wide moats; they're insulated from the ravages of creative destruction. A quality strategy, then, should capture the essence of Buffett's moat-investing philosophy, and indeed that's what many professional investors profess to do: buy great companies at reasonable prices, also known as "growth-at-a-reasonable-price," or GARP, investing.

Does the newly launched iShares MSCI USA Quality Factor ETF (NYSEARCA:QUAL) capture some of Buffett's essence? I dare say it does. Now, I'm not claiming you're going to get Buffett-like results by owning this fund. It's a pale imitation of the real thing. (I have a huge chunk of my personal assets in Berkshire Hathaway (NYSE:BRK.B).) However, it's clear that MSCI took its inspiration from all the right places when it devised the index.

In the early 1980s, Buffett began advertising Berkshire's acquisition criteria (the emphasis is mine):

"We prefer:

(1) large purchases (at least $5 million of after-tax earnings),
(2) demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations),
(3) businesses earning good returns on equity while employing little or no debt,
(4) management in place (we can't supply it),
(5) simple businesses (if there's lots of technology, we won't understand it),
(6) an offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown)."

Compare that with the MSCI Quality Index, which selects stocks with:

1) high return on equity ("good returns on equity"),
2) low debt/equity ratios ("little or low debt"),
3) low variability in their year-over-year per-share earnings growth over the trailing five years ("consistent earnings power").

All the quantitative criteria Buffett describes are there, though MSCI doesn't exclude technology firms. The index's selection rules are simple, common-sense interpretations of Buffett's criteria.

This by itself doesn't mean the index can capture Buffett's magic. (It can't.) Buffett takes into consideration valuation, managerial quality, and his assessment of the industry's future dynamics, among other things. He doesn't make many purchases, and when he does he keeps them, whereas this index buys more than a hundred companies and can churn them during its semiannual rebalances. The best that can be said is that if Buffett buys the needle, the index buys the haystack. However, that need not invalidate the strategy, because it's buying the haystacks where Buffett tends to find needles.

We don't have much live performance data for QUAL, which was launched in July. So we have to resort to MSCI's hypothetical return data, which begins in December 1981. The starting date is a little suspicious--why 1981, when MSCI has the data to go back further? Probably because quality stocks took a savage beating during the 1970s. They achieved lofty price/earnings multiples during the Nifty Fifty craze and became relatively cheap by 1980. According to a study on quality strategies conducted by MFS, quality stocks (defined using somewhat different criteria) underperformed the broad market by more than 20% from 1975 to 19801.

(click to enlarge)

Even with the 70s bust excluded, the quality index beat the broad-market MSCI USA Index by only 1.7% annualized. So what's the excitement about?

For one, the boost is about as consistent as you could ask for in a non-fraudulent, non-data-mined return series. Exhibit 2 shows the cumulative total return of the quality index divided by the cumulative total return of the MSCI USA Index. When the line slopes up, quality is outperforming; when it declines, quality is underperforming. It seems that as long as quality stocks don't trade at extreme valuations, they enjoy a persistent performance edge over a full business cycle.

(click to enlarge)

In addition, after taking into account the index's tilts to value, size, and momentum factors, its annualized excess returns rise to 3.1%. Adding the fund to a conventional equity portfolio may result in decent diversification benefits. GMO argues that U.S. quality stocks aren't trading at the valuation premiums they've historically commanded, making them relatively attractive. Indeed, QUAL's aggregate forward price/earnings, price/sales, and dividend yield aren't much different from the S&P 500's, even though QUAL's holdings have experienced faster growth in earnings, sales, cash flow, and book value. As of June 30, GMO expects U.S. quality stocks to earn 3.7% annualized after inflation during the next seven years, much better than the negative returns it expects the aggregate market to experience.

Out of curiosity, I checked whether the MSCI Quality Index could "explain away" the historical excess returns of GMO Quality III (MUTF:GQETX) and Jensen Quality Growth (MUTF:JENSX), Silver- and Gold-rated funds, respectively. Lo and behold, it could. In fact, once you control for the funds' substantial loadings to the quality factor, they actually underperformed, suggesting that both funds' historical returns can be passably mimicked by MSCI's mechanical quality strategy.

iShares vs. Vanguard
I've described Vanguard Dividend Appreciation VIG before as a "Buffett in a box." I like the strategy. It's cheap, well-managed, liquid and, most importantly, sensible. Over the long run, I expect it to beat the market on a risk-adjusted basis. (A high-up Vanguard executive once said he expects VIG to be the best-performing Vanguard fund over the next 100 years. I wouldn't go that far, but I don't think the sentiment is too far off the mark.) VIG works because it buys quality stocks, which have economic moats that enable them to grow their earnings (and dividends) through thick and thin.

There's nothing magical about VIG's methodology: It uses a rather blunt rule--10 years of uninterrupted dividend increases--to pick its holdings. Such rules are robust, but they can miss nuance. The index's original creator, Mergent, added some secret screens to weed out firms that might cut their dividends, a minor blemish to the fund's otherwise sterling qualities.

The burning question: Is QUAL better than VIG?

On the pro side of the ledger: QUAL offers purer exposure. It mixes several reasonable signals and it weights its holdings by multiplying the quality scores by market weightings. I also like the index's transparency. VIG, on the other hand, focuses on one signal and weights holdings by market cap, diluting its exposure to the highest-quality stocks (though likely not by much, as such firms tend to be big). I don't like VIG's use of secret sauce (let's be real--no one's going to steal the recipe), even if it seems to have produced reasonable results.

On the con side: QUAL charges a slightly higher expense ratio (0.15% versus VIG's 0.10%) and is less liquid. (Always use a limit order when buying this fund, but not before consulting the indicative net asset value.)

For what it's worth, I'm not in a rush to dump my shares in VIG for QUAL, but I'll be considering it over the next few months.

1Katrina Mead, Jonathan Sage, and Mark Citro. "Power Couple: Quality and Value Are Strong Drivers of Long-Term Equity Returns." MFS, 2013.

A version of this article appeared in the August 2013 issue of ETFInvestor.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: QUAL: Another Buffett-In-A-Box?