Understanding The Quality Factor

| About: PowerShares S&P (SPHQ)

This is Part 7 in a series about smart beta ETFs. 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 (NYSEARCA: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 (NYSEARCA: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 (NYSE:PG), Verizon (NYSE:VZ) and GE (NYSE: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.