FlexShares Solves Quality ETF Conundrum

Among factor-based exchange traded funds, quality is perhaps the most emphasized factor. That much is proven by a spate of new fund launches that, when including international offerings, has brought the number of quality ETFs listed in the U.S. today to around 40.

One issue investors need to consider as they peruse quality ETFs from various fund sponsors is that the definition of quality often varies from issuer to issuer.

“There are a lot of issuers with an explicit definition of quality,” said FlexShares Managing Director and Head of Exchange Traded Funds Shundrawn Thomas in an interview with ETF Trends from the Morningstar ETF Conference in Chicago. “We think of quality as a discernible factor with a real contribution to return analysis.

The FlexShares approach to the quality factor is on full display in the issuers suite of dividend ETFs, including three U.S.-focused products that are approaching their second anniversaries. Those ETFs are the FlexShares Quality Dividend Index Fund (NYSEArca: QDF), FlexShares Quality Dividend Dynamic Index Fund (NYSEArca: QDYN) and the FlexShares Quality Dividend Defensive Index Fund (NYSEArca: QDEF).

The $521 million QDF is the largest of the trio, but QDEF and QDYN are increasingly popping up on investors’ radars. QDYN, which holds companies that “are selected based on expected dividend payment and fundamental factors such as profitability, solid management, and reliable cash flow,” according to FlexShares, is now a $93.2 million ETF after adding almost $68 million in new assets this year. [Dividends and Quality Meet in This ETF]

QDEF has added over $30 million of its $86 million in assets under management since the start of the year, serving as another sign that the right application of the quality factor can prove attractive to investors. An important element to FlexShares’ quality approach is the persistence of profitability.

“Profitability provides a discernible competitive advantage,” said Thomas. “We look at measures that evaluate the persistence of profitability because high quality companies should perform above the industry average.”

On a related note, one that is critical to dividend ETFs and income investors, is the FlexShares emphasis on management efficiency and a company’s ability to generate cash.

“Bad management can destroy a good business,” notes Thomas. “Cash is king with publicly traded companies. When you look at cash flow, it’s something that can’t be faked or manipulated.”

By emphasizing factors such as return on assets and return on capital, derivatives of the quality factor, over more prosaic measures such as dividend increase streaks, QDF and its brethren ETFs have handsomely outperformed some highly popular dividend ETFs since coming to market in December 2012. [Dividend ETF Shows its Strength]

As evidenced by the relatively low combined weights to the high-yielding telecom and utilities sectors across QDF, QDEF and QDYN, the ETFs help investors steer clear of the mistake of picking a dividend ETF based simply on a stout yield. After all, some high dividend yields on some stocks could be signs of financial stress and a potentially strained payout.