Smart beta exchange-traded funds (ETFs) and mutual funds generally use one or more factors in determining their mix of underlying stocks or other assets. Often these factors are a sub-set of a more standard index like the S&P 500 or the Russell 2000. Some typical factors include value, momentum and size. Another popular factor is quality.

What is Quality?

Quality might be one of the most difficult factors to define. Some characteristics associated with high-quality strategies include various measures of profitability, stability of earnings, or other measures, and the financial health of the company. A study by AQR Capital Management published by Yale University found that stocks with high and growing profits, high payout rates combined with low volatility and fundamental risk historically outperformed their lower quality counterparts. (For more, see: Smart Beta ETFs Strategies.)

Examples

In 2015 Blackrock's iShares Edge MSCI USA Quality Factor ETF (QUAL) gained 5.46% according to Morningstar. This compares to a 1.38% gain for the S&P 500 Index for the same period. The ETF was launched in 2014 and underperformed the index for that year, and so far this year the fund is 1.21% behind the S&P 500. As Morningstar points out, however, quality factor beta funds tend to perform particulary well in tough market conditions. 

QUAL tracks the MSCI Sector Neutral Quality Index. The index tracks the performance of large and mid-cap stock which are based on return on equity, earnings variability and debt equity.

The PowerShares S&P 500 Quality Portfolio (SPHQ) has a longer history. In 2015 the ETF gained 1.67% versus 1.38% for the index. YTD as of late July 2016 the return was 11.14% versus 7.66%. Additional trailing results for the ETF versus the S&P 500 include: 

  • An average annual gain of 13.93% versus 12.39% for the trailing three years.
  • An average annual again of 16.02% versus 14.85% for the trailing five years.
  • An average annual gain of 7.01% versus 7.53% for the trailing ten years.

SPHQ tracks the S&P 500 Quality Index. The index tracks companies in the S&P 500 index that has the highest "quality score" based on return on equity, accruals ratio and financial leverage ratio. Both the fund and the index are rebalanced semi-annually in June and December.

The expense ratio for SPHQ is 29 basis points and 15 basis points for QUAL. By comparison the SPDR S&P 500 ETF (SPY) has an expense ratio of 0.09% while the Vanguard S&P 500 ETF (VFV) has an expense ratio of 0.08%. Both are traditional market-cap weighted index ETFs. SPY is one of the highest volume ETFs currently traded. (For more, see: 4 Most Traded ETFs This Year.)

SPHQ and QUAL are the two largest smart beta ETFs focusing purely on quality. However, there are a number of other smart beta ETFs that focuses on more than one factor. As an example of how these “combo smart beta ETFs” work, Morningstar describes Goldman Sachs' security selection and weighting criteria in the following way; “Quality is one of four sub-portfolios in Goldman Sachs’ ActiveBeta Indexes. Quality is measured by dividing gross profit by total assets or by return on equity in the case of financial stocks – where gross profit is not available. Stocks are over/under weighted relative to their weighting in the parent index depending upon whether their factor score falls above/below a cutoff score.” (For more, see: Building a Better Mousetrap with Smart Beta ETFs.)

Quality and Outperformance

In recent years high quality stocks have outperformed the S&P 500 index. These companies are by definition less risky and better equipped to survive tough economic periods. The stocks reflect this by typically exhibiting less volatility than the market as a whole. Quality reflects many of the ideals of legendary investor Warren Buffet which is buying “… wonderful companies at a fair price.” In fact, the report by AQR Capital Management referenced the importance of price in buying stocks that exhibit the characteristics of quality.

The Nifty Fifty stocks of the 1960s and 1970s are a good illustration. These were the high quality stocks of the 1960s and investors continued to buy and/or hold them even after their valuations became absurdly high. When the stock market fell hard in the early 1970s these stocks fared worse than the S&P 500 and took longer to recover than the index overall.

The Bottom Line

Smart beta factor investing is a twist on traditional market-cap weighted index investing. One popular factor is quality. Quality stocks have largely outperformed the S&P 500 of late, but this outperformance will not be indefinite. The typical characteristics of quality stocks are important but so is the price paid and the relative valuation of these stocks and the ETFs that utilize this investing factor. (For more, see: Smart Beta ETFs: The Pros and Cons.)

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