A growing number of exchange traded funds are advertised as quality funds. To be precise, there were 23 such ETFs on the market as of early August, but not quality ETFs attack the quality factor in the same fashion.
Although most the quality ETFs have burst onto the seen in recent years with a spate of new launches this year, questions remain about how exactly the quality factor is defined. The quality factor “captures excess returns to stocks that are characterized by low debt, stable earnings growth and other ‘quality’ metrics,” according to MSCI.
An emphasis on quality stocks has helped make the iShares MSCI USA Quality Factor ETF (NYSEArca: QUAL) a $479.2 million ETF in the span of just 13 months on the market. QUAL tracks the MSCI USA Quality Index. That index emphasizes return on equity, earnings variability and debt-to-equity in the selection of large- and mid-cap U.S. stocks, according to iShares. Four of the QUAL’s top-five holdings are Dow components with Apple (NasdaqGS: AAPL) the outlier. The other four are Microsoft (NasdaqGS: MSFT), Johnson & Johnson (NYSEL JNJ), IBM (NYSE: IBM) and Exxon Mobil (NYSE: XOM). [Quality ETFs on the Rise]
In terms of quality, Apple and Exxon are the two largest dividend payers in the S&P 500, Johnson & Johnson has one of the longest dividend increase streaks of any U.S. company and Apple and IBM were two of the largest S&P 500 share repurchasers in the second quarter.
Speaking of the application of dividends in the quality factor, investors’ attraction to quality dividend stocks has made the FlexShares Quality Dividend Index Fund (NYSEArca: QDF) a $515 million ETF after debuting in December 2012.
“FlexShares says its back-testing demonstrates that adding a quality factor greatly increases returns over a pure high-dividend strategy. Its index’s back-tested results over the past 35 years would have produced a 20.3% annualized return, compared with 15.8% for the highest-yielding stocks, and 12.5% for the broad stock market,” reports Lewis Braham for Barron’s.
However, as Barron’s notes, back-tested results can often mislead. Out in the real world, QDF has returned 40.2% since coming to market. Since QDF debuted, the Vanguard Dividend Appreciation ETF (NYSEArca: VIG), the largest U.S. dividend ETF, is up 30.7%. [A Dividend ETF That Beats Rising Rates]
QDF’s trailing 12-month yield of about 2.7% is not eye-popping, but there is an advantage there. Obviously, QDF’s low yield is the result of low yields found on many of the ETF’s 2012 holdings. Only five of the ETF’s top-10 holdings yields over 3% and Altria (NYSE: MO) that yields north of 4%.
The advantage is that a lower yield often implies a safer payout and more room for potential dividend growth. A recent study of U.S. dividend ETFs by Credit Suisse assessing the safety of the payouts of those funds’ underlying holdings found that QDF has one of the safest fixed coverage ratios. [Dividend ETF Flexes its Muscles]
There is something to how FlexShares marries dividends and the quality factor in its suite of three U.S.-focused dividend ETFs.
The FlexShares Quality Dividend Defensive Index Fund (NYSEArca: QDEF) and the FlexShares Quality Dividend Dynamic Index Fund (NYSEArca: QDYN) debuted on the same day as QDF. Although smaller than QDF, QDEF and QDYN have returned 35.4% and 41%, respectively, since coming to market, offering substantial out-performance of VIG along the way.
FlexShares Quality Dividend Index Fund
