The quality factor has been one of the standout investment factors this year and plenty of exchange traded funds (ETFs) are participating in that trend. Among dedicated quality ETFs, the Invesco S&P 500 Quality ETF (NYSEArca: SPHQ) is a 2019 leader.

However, some market observers are expressing concerns about the recent strength in quality stocks. SPHQ, which debuted in late 2005, follows the S&P 500 Quality Index. That index tracks S&P 500 members “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 Invesco.

“Under the current U.S. Goldilocks economy, with moderate growth and low inflation, high-quality stocks have been benefiting handsomely this year,” reports Evie Liu for Barron’s. “But the market might have given them more credit than they deserve, and the group could be susceptible to volatility if the economy were to shift significantly, either up or down.”

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.

Quality Concerns

“Quality stocks might be at risk, however, as their prices start to get too expensive, warns Wilson,” reports Barron’s. “By the end of Thursday, the S&P 500 Quality index was trading at 18.8 times forward earnings, just slightly below its latest high, reached last September, and well above the S&P 500’s 16.6 times.”

Another potential concern is sector concentration in some quality strategies. For example, SPHQ allocates 42% of its weight to tech stocks, more than quadruple its second-largest sector weight.

Quality has historically outperformed other investment factors during economic slowdowns, but that thesis could be challenged if quality ETFs amass large positions in cyclical sectors, such as tech.

“Over the past decade, many young tech companies have grown bigger and seen their balance sheets significantly improve. As a result, these names started to fit the profile of the high-quality group, which historically has been dominated by shares from more-stable sectors, such as industrials, health care, and consumer staples,” according to Barron’s.

For more information on investing strategies, visit our Core ETF Channel.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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