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Several times a week, Seeking Alpha's Jason Aycock asks money managers about their single highest-conviction position - what they would own (or short) if they could choose just one stock or ETF.

Michael Paciotti is co-founder and chief investment officer at Integrated Capital Management, managing money for institutions and high-net-worth individuals. A CFA, he previously was responsible for overseeing proprietary investment programs for Guardian Life Insurance Company's $3 billion advisory business.

Which single asset class are you most bullish (or bearish) about in the coming year? What ETF position would you choose to best capture that?

We view high financial quality equities, those with low debt and high and sustainable ROE, as an overlooked segment of the market and one of the best relative values available today. There are a handful of ETFs that can be used to capture quality, but none more specific than the PowerShares S&P 500 High Quality Portfolio ETF (PIV).

How does PIV fit into your overall investment approach? Tell us a bit about your strategy and goals.

Our approach incorporates elements of both philosophy and process into investing. This approach stems from a contrarian valuation-oriented philosophy and the belief that inefficiencies exist across asset classes and all other common-factor beta exposures. By overweighting those opportunities that are inexpensive and underweighting those that are expensive, we believe that investors can reduce risk and enhance return over the course of a full market cycle.

PIV chartFrom a process perspective, our process is a Global Tactical Asset Allocation (GTAA)-based model that establishes relative valuations among asset classes and other common-factor beta exposures. Information is synthesized through a multifactor model using market-based inputs and a proprietary adjustment process to normalize for dynamics like varying risk levels between assets or key macroeconomic factors.

We are intent on understanding what markets imply by their current valuation, since markets tend to extrapolate recent events in a linear fashion to an unsustainable conclusion. Our portfolios are broadly diversified, but favor a series of assets likely to benefit from mean reversion.

Tell us a little more about the area of high quality. What makes it your top pick?

Quality is a characteristic that transcends style and market cap, although high-quality names typically have more in common with growth and large-cap than they do with small and value spaces. We define high quality as those organizations with low debt and high and sustainable ROE. Using S&P Earnings and Dividend rankings, these would be organizations rated A or better. Richard Tortoriello, Director of S&P Equity Research Group, did a wonderful job on this in his Quality Trends report and was a great help to us in conducting our research. We find high-quality equities attractive for three main reasons.

  1. For all of these desirable characteristics (low debt, high and sustainable ROE), over longer periods high-quality names typically outperform their lower-quality counterparts. What’s more, high quality does so while generating lower variability of returns in bad markets and overall than lower quality (standard deviation of 15.67 vs. 23.68 over the past 10 years, and semi-standard deviation (downside risk) of 11.1 and 16.1 respectively). Therefore, the combination of higher returns with lower variability goes a long way to minimizing variance drain.

  2. From July of 1999 through March of 2003 (the Internet bubble bear market), the S&P 500 High Quality Index outperformed the low quality index by 19.32%. This left high quality, depending on the metric used, between 1.5 and 2.5 standard deviations overvalued compared to low quality. This in turn led to an eight-year period where low quality dominated high quality by more than 90% in cumulative total return. We now have the opposite environment where high quality is between 1.5 and 2 standard deviations undervalued.

  3. As mentioned in point No. 1, high quality exhibits defensive characteristics. One of the detriments of a central bank intent on stimulating an economy via a wealth effect is by inflating asset prices artificially, you end up with most assets becoming overvalued simultaneously. Through November, our models had broad equity markets still within fair-value range but fast approaching what we would classify as expensive (one standard deviation above fair value). Within equities, small is by far worse than large and equity REITs may be worse than small caps. Fixed-income markets, especially Treasurys, passed into expensive territory a long time ago.

    Ironically, the opposite is true in fixed income as opposed to equities. Whereas in equity markets, the risk trade has all but evaporated, risk assets within fixed income are the best of a bad bunch. The point of all of this is that most assets are expensive. In an overvalued market, if you can find one with both defensive characteristics and inexpensive valuations we feel that those characteristics are tremendously appealing.

With your goal of high quality in mind, how do you feel about PIV from a diversification standpoint? In terms of stability, it's low on certain defensive areas (4% in Utilities, just under 9% in Health), while heavy on Consumer Goods (22.5%) and Consumer Services (21.3%). No telecom or software to be found.

The portfolio is broadly diversified across 123 names. We use positions like this as meaningful pieces of our strategy but not in isolation. Our portfolios are constructed with rather large active bets toward quality relative to their benchmarks but are diversified across other core assets.

For instance, within domestic equities we are diversified across growth, value, large and small but do that as the foundation of the portfolio. Then we add positions like high quality or a growth overweight to have a meaningful impact on active returns. High quality is part of our strategy but not our entire strategy.

With regard to sector allocation and the defensive nature of quality, we need to remember that certain sectors that have a reputation of being defensive aren’t always defensive. In 2001-2002, Utilities trailed the S&P 500 by nearly 20%. High quality outperformed by 22%. In 2008, Utilities did outperform by 800 basis points. Quality did OK too, outperforming by 400 basis points. The danger with relying on sector bets for defensive posturing is that they don’t always work. There can be industry-specific factors, or valuations for that matter, that cause an overpriced traditionally defensive sector to not act defensively.

We prefer a more broad based defensive positioning like what you get through a quality allocation. From 1997, the inception of the S&P Quality Based Indices, high quality has a semi-standard deviation (downside risk) of 11 vs. 12 for the traditionally defensive utility sector and 11.8 for the overall market.

All of that said, you make a very valid point. One needs to be mindful of the fact that there are sector bets here. A more sector-neutral, cap-weighted index of high-quality names would be better for what we are trying to do. That is to overweight quality without unintentionally indexing other common factors. Considering both the pros and cons, we think that the pros by far outweigh the cons, especially in an environment where most assets are overvalued.

Are there alternative ETFs that could be used to capture the same theme? What makes PIV your first choice?

There are a few. Mega cap has traditionally been highly correlated with quality. This is what we used back in 2006. A long history of rising dividends can also be a proxy for quality. We’ve used and continue to use the Vanguard Dividend Appreciation VIPERs (NYSEARCA:VIG) in our portfolios. The problem with using proxies is that it wasn’t necessarily intended to be a quality portfolio, the characteristics can change, or in most instances you must tolerate other factor bets that perhaps may be unwanted. PIV goes directly to the source and indexes quality.

Does your view differ from the consensus sentiment on high quality?

The trend has definitely been in the lower quality names. There are a handful of firms with similar views, although I would consider us to be in the minority. Keeping in mind that we have been fans of quality since 2006 when we first established an overweight to quality, we were really in the minority. It wasn’t so hard to justify in 2008, where it worked remarkably well. Not surprisingly, given our contrarian thought process we moved away from it in early 2009. Given the tremendous rally in junk we rotated back toward quality late in 2009 and are even higher on it today than one year ago.

What catalysts, near-term or long-term, could move this area significantly?

Deceleration in earnings, widening credit spreads and negative equity risk premiums are all catalysts that could drive outperformance of high quality over low quality. Ultimately, in our opinion, the most meaningful is valuation compression. Eventually, you get to the point of being absurd when you consider that quality companies that typically trade at a premium to the market, and to junk, are now at a 14% discount on trailing 12-month earnings and a 12% discount on FY11 earnings. Statistically, this should trend in the other direction.

What could go wrong with your pick?

From a relative performance perspective, junk could continue to rally if the Fed continues its current course of stimulating via the wealth effect. The quality premium is typically negatively correlated with the equity risk premium and narrow credit spreads. Given the apparent goal of the Federal Reserve to stimulate economic activity by driving investors out of Treasurys into other risk assets, this will, in our view, further inflate (albeit artificially) junk-stock valuations well into bubble territory.

Additionally, credit spreads are approximately average in the high-yield bond market. When you consider that the high-yield market is a source of financing or at least a proxy for the cost of debt capital for lower-credit quality organizations, the difference between what higher-quality companies can finance at and lower-quality companies can finance at is not meaningful. Both can finance fairly inexpensively even if the average spread is intact. This may need to widen some before quality begins to work. In either case, we believe that junk continuing to rally is akin to stretching the rubber band, and is unsustainable. The farther this stretches, the greater the snap back, with mean reversion as an inevitable conclusion.

Thank you, Michael, for sharing your thesis with us.

Disclosure: Long positions in PIV and VIG.

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Source: Just One ETF: Getting Back to Quality With Focus on Low Debt, High ROE