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By Abby Woodham

Interest in quality investing has heated up in recent years, triggering the release of new quality-oriented exchange-traded funds. Several respected academics have released papers that aim to quantify quality/profitability's role as a predictive metric. What are arguably the three most important reports have come in quick succession: "Quality Minus Junk" by Clifford Asness, Andrea Frazzini, and Lasse Pedersen; "The Other Side of Value: The Gross Profitability Premium" by Robert Novy-Marx; and "A Five-Factor Asset Pricing Model" by Eugene Fama and Kenneth French. Their findings are consistent--profitable (high-quality) firms outperform unprofitable firms over time. However, do investors need pricier ETFs that target quality? As it turns out, there's an even cheaper way to access the quality (and sometimes value) premiums: through a dividend ETF, the old stalwart.

Research Background

Novy-Marx's research shows that profitable firms, as defined as those with high relative gross profits/assets, outperform unprofitable firms. He also found that this ratio is about as successful as book/market as a predictor of future returns. Investors often use metrics like net earnings and return on equity to quantify profitability, but Novy-Marx's research suggests that "purer" accounting measures better represent true profitability by not penalizing firms for engaging in research and development, advertising, or other activities that reduce net earnings today but boost them in the future.

Asness and his team from AQR Capital also found that high-quality stocks outperformed low-quality firms on a risk-adjusted basis. They define quality as a combination of four metrics: profitability, growth of profitability, safety, and the payout ratio. In their paper, they construct a quality minus junk factor, or QMJ, that can be used to test whether a portfolio's historical return was driven by quality. QMJ sorts the market by how they score on the four aforementioned quality metrics, then shorts the bottom 30% of junk stocks and goes long the top 30% of high-quality stocks. They found that QMJ portfolios not only outperform junk stocks on a raw return basis, but outperform even further on a risk-adjusted basis. When combined with other factors like high minus low (HML, or value), small minus big (SMB, or size), up minus down (UMD, or momentum), and market return minus the risk-free rate, the QMJ factor is very useful in explaining returns for diversified portfolios.

Combining Quality and Value

Another important takeaway from both papers is that value strategies are improved by controlling for profitability, and profitability strategies are improved by controlling for value. The takeaway, with respect to portfolio construction, is to sort constituents for both quality and value. Such portfolios outperformed those that only sorted for book/market or gross profits/assets.

Combining value and quality is not a new concept by any means. The strategy is summarized as "quality at a reasonable price," which should sound familiar to many investors. Warren Buffett and Charlie Munger's philosophy that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price" precedes these new pieces of research by decades. Looking even further back, Benjamin Graham advocated investing in value stocks that met minimum quality requirements.

Direct and Indirect Quality

Two of the largest explicitly quality-oriented ETFs are iShares MSCI USA Quality Factor (NYSEARCA:QUAL), which charges a 0.15% expense ratio, and PowerShares S&P 500 High Quality (NYSEARCA:SPHQ), which costs 0.29%. QUAL sorts stocks by return on equity, debt/equity, and earnings variability, before weighting them using a combination of the resulting quality score and their market capitalization. SPHQ's constituents are sorted according to their S&P 500 Quality Rankings, which measure earnings growth and stability and dividends per share during the past 10 years. Stocks with the highest three ratings are included, and the index gives equal weighting to stocks in the same ranking. The mandate for both funds is to try to provide exposure to the quality factor.

But there's an indirect way to access quality: dividend ETFs. Not all dividend ETFs are successful at constructing a high-quality portfolio, but a handful are just as capable as--and sometimes better than--the quality-oriented funds at harnessing the quality factor.

For a historical perspective, let's return to AQR's QMJ factor. I regressed the monthly returns from May 2006 to the end of 2012 of SPHQ and QUAL's indexes, as well as the indexes of several popular dividend ETFs, against the return factors discussed earlier. For ease of use, each column is identified by the ticker of the ETF that tracks the index today.

All of the dividend ETFs had statistically and economically significant exposure to QMJ, often exceeding that of the quality ETFs. This finding makes intuitive sense because dividend payers tend to be associated with quality metrics: high profitability, stable earnings, low debt, and good payout ratios. As a group, the dividend ETFs also tilted to value. Value tilts are common among dividend ETFs because most incorporate a screen for dividend yield. Higher-yielding companies tend to trade at a relatively cheaper valuation.

The Qualitative Approach

Regression data is useful in identifying ETFs that historically captured the value and quality premiums, but it is critical to consider the funds' methodologies and current portfolios to determine if they are likely to continue to do so in the future.

The standout dividend ETF within the context of combining quality and value is Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD), which tracks the Dow Jones U.S. Dividend 100 Index and costs just 0.07%. Its quality tilt is higher than that of QUAL or SPHQ, which comes as a surprise until SCHD's index construction is considered. The fund's index includes only large, liquid companies that have paid dividends in each of the past 10 consecutive years, and it requires constituents to score well on four fundamental metrics: cash flow/debt, return on equity, dividend yield, and dividend growth. These are explicit quality screens. SCHD weights constituents by market cap, which results in a large-cap tilt, and the index's dividend-yield screen results in a meaningful value tilt. The fund's past performance and index methodology are good indicators that SCHD will continue to harness value and quality going forward.

Vanguard Dividend Appreciation (NYSEARCA:VIG) targets quality, but not value. Morningstar ETF strategist Samuel Lee considered VIG's quality tilt in a recent article. It also has a cost advantage by charging a 0.10% expense ratio.

iShares Select Dividend (NYSEARCA:DVY) is a good example of when factor exposures don't tell the full story. Its loadings on value and quality are huge, but its negative alpha should give pause. This may be due to DVY's construction approach. The fund employs screens to reduce the risk of dividend cuts, primarily by excluding firms that pay out too much of their earnings or have not grown their dividend-per-share ratio during the past five years. It then selects the highest-yielding stocks and weights them by indicated annual dividend. This pushes the fund into deep-value territory, and the resulting portfolio is tilted to defensive mid-cap stocks and is less correlated with the broad U.S. market than other dividend ETFs.

Another measure of quality is the percentage of an ETF's assets that have a wide Morningstar Economic Moat Rating. The moat rating attempts to quantify how likely a company will be able to keep competitors at bay for an extended period. Wide-moat stocks are those that Morningstar analysts believe will earn above-average returns on invested capital over the long term.

The results back up the regression findings, as well as the qualitative assessments of the funds' methodologies. The three funds with the most emphasis on wide-moat stocks are QUAL, SCHD, and VIG. DVY and SPHQ lag behind.

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: Hidden Quality In Dividend ETFs