A Quality Way to Reduce Volatility

When equity market volatility spikes, as it did in early February, investors may be prone to stocks and exchange-traded funds (ETFs) that fall under the jurisdiction of the low volatility factor. That is a sensible approach, but other smart beta ETFs can help investors boost volatility protection.

Funds that emphasize the quality factor, such as the iShares Edge MSCI USA Quality Factor ETF (QUAL), can help investors endure periods of elevated volatility. Pillars of quality stocks often include low debt, dividends, strong management teams and robust return on invested capital (ROIC), among other factors. For its part, QUAL's holdings are evaluated based on return on equity, earnings variability and debt-to-equity, according to iShares.

Year to date, QUAL is up 4.61%, a performance that is mostly in line with that of the S&P 500. Quality stocks offer investors some compelling advantages to consider. "First, quality has historically delivered a return premium, i.e. the opportunity to outperform a broad benchmark over the long term. Since 1990, the MSCI Quality Index has beaten the S&P 500 by approximately 0.10% per month on average," said BlackRock in a recent note.

QUAL, which is nearly five years old, tracks the MSCI USA Sector Neutral Quality Index. The $4.58 billion ETF does an admirable job of reducing volatility. QUAL's three-year standard deviation of 9.76% is slightly below the comparable metric on the S&P 500. The ETF could be one to consider if U.S. stocks scuffle over the course of 2018. (For more, see: QUAL vs. PRF: Comparing Smart Beta Funds.)

"In addition, quality tends to perform best when other styles, and the broader market, are struggling," said BlackRock, Inc. (BLK). "Quality typically outperforms momentum during periods of turbulence. During the most recent pullback, quality once again outperformed, albeit by a relatively small margin. Most likely, part of the reason quality did not offer more protection was the nature of the selling."

QUAL holds 125 stocks, 25.7% of which are technology names. The ETF devotes 28.1% of its combined weight to financial services and healthcare stocks. Apple Inc. (AAPL), 3M Company (MMM) and NVIDIA Corporation (NVDA) are among the ETF's top 10 holdings.

While growth and momentum have been winning factors for a couple of years now, historical data suggest that quality can reward long-term investors. "Over the long term, quality has proved its worth, particularly during periods characterized by rising volatility," according to BlackRock. "Since 1990, in months when the VIX rose by 20% or more, quality beat the S&P 500 by an average of approximately 60 basis points (bps, or .60%). Nor is the average a function of a few, very good months. When volatility was rising sharply, quality beat the broader market 75% of the time." (For additional reading, check out: Strategies to Volatility-Proof Your Portfolio.)