The quality factor is a point of emphasis for a growing number of strategic beta exchange traded funds. Though there has been debate surrounding defining quality as it pertains to factor-based investing, quality companies and dividend-paying stocks often go hand-in-hand because those dividends are seen as signs of stable earnings and thoughtful management.
An array of ETFs focus on quality stocks using varying methodologies and one of the older quality ETFs is the PowerShares S&P 500 High Quality Portfolio (NYSEArca: SPHQ). SPHQ’s underlying index, the S&P 500 Quality Index, features members of the S&P 500 “that have the highest quality score, which is calculated based on three fundamental measures, return on equity, accruals ratio and financial leverage ratio,” according to PowerShares.
While the quality and value factors often appear together across various stocks and ETFs, that should not be interpreted to mean that all quality stocks and ETFs are discounted relative to the broader market. During periods of elevated market volatility, the quality factor has historically posted better returns relative to other investment factors.
Stocks found in SPHQ “have tended to hold up a little better than average during market downturns, though that is not always the case,” said Morningstar in a recent note. “For instance, during the bear market from Oct. 8, 2007, through March 9, 2009, the fund’s index lost slightly more than the S&P 500. The fund does not have a long record tracking its current benchmark. The back-tested performance of its index looks good overall, but as always, it is prudent to discount such hypothetical performance.”
Valuing high quality value is particularly important as bull markets enter their waning stages, as some market observers believe the current bull market is doing. In the early stages of bull markets, lower quality companies see their shares soar. However, as the bull matures, investors often exhibit a preference for higher quality fare with more compelling valuations.
“The types of quality stocks the fund targets are unlikely to offer eye-popping returns, and they could lag the market for extended periods, particularly during strong market rallies. So they are probably not attractive to aggressive investors, which could cause them to become undervalued. These stocks should reward patient investors with a better risk/reward profile than the broader market over the long term,” according to Morningstar.
SPHQ is up 8.6% this year.
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