In Times Of Eerie Calm, Don't Neglect Quality

by: Russ Koesterich, CFA

Quality stocks may be out of favor in this environment, but Russ explains the important role they can play in a portfolio.

This has been a good but peculiar year for stocks. The fact that global markets are having one of their best years since the financial crisis is not in itself remarkable; the way it has occurred is.

The rally has been led by a strange combination of risk-on favorites - such as emerging markets, secular growers and classic defensive plays, like U.S. healthcare. The year has also been distinguished by low volatility, both upside and downside: There have been few corrections, but also a relatively small number of memorable one-day advances.

Instead, there has been a slow, relentless grind higher. Given this environment, it is not surprising that momentum stocks have dominated, particularly in the United States. The MSCI USA Momentum Index has gained roughly 30%, about twice the gains for the MSCI USA Enhanced Value Index or quality stocks, as represented by the MSCI USA Sector Neutral Quality Index (source: Bloomberg, as of 10/18/17). Given the magnitude of the outperformance, it's not entirely surprising that we've started to witness a bit of catch-up from value and quality.

In previous blogs, I've made the argument to consider adding some value back into a portfolio. I would make the same argument for quality. To be fair, quality is harder to define. Generally, when investors talk about quality, they are referring to large, stable companies with at least three common characteristics: high return-on-equity, earnings consistency and low debt.

There are two arguments in favor of adding quality to a portfolio - either directly through a stock screen or an exchanged traded fund (ETF). First, there is a strategic argument. Looking at style factors within a broader multi-asset portfolio, quality generally receives a high allocation. Targeting a 9% total portfolio risk, i.e. a typical 60/40 stock/bond blend, a mean-variance optimization (MVO) suggests 9.0% allocation to quality. This is approximately 2.5 percentage points higher than a theoretical allocation to momentum.

Quality can help mitigate risk

The large allocation to quality is not a function of a generous return assumption, but is instead driven by quality's historical risk mitigating properties. Quality companies tend to be stable, and by extension their stocks less volatile. For example, the one-year volatility (in other words, how much the stocks' prices fluctuate relative to history) of the MSCI U.S. Sector Neutral Quality Index is roughly 20% lower than for either the respective MSCI value or growth indexes (source: Bloomberg, as of 10/18/17). Which brings me to the second, related argument for quality: The style is arguably most relevant when volatility is rising.

Volatility changes things

Historically, momentum stocks outperform quality. However, this dynamic has flipped when volatility was increasing. Testing this theory, since 1990 in months when the VIX Index advanced by more than 10%, quality outperformed momentum by an average of approximately 25 basis points (bps or 0.25%), or 300 bps annualized.

The nature of quality provides a reason for considering the style within a broader portfolio. The argument may become stronger when you expect a pickup in volatility. And as unusual as that would seem in a year like this one, it's hard to predict where volatility could go from here.

This post originally appeared on the BlackRock Blog.

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