Quality is always in fashion, but in 2021, it’s been on quite a tear, with advisors pouring billions into quality ETFs and mutual funds. Will the trend continue in 2022?
Recently, ETF Trends’ managing editor Lara Crigger sat down with American Century Investments’ vice president of ETF Product and Strategy Sandra Testani to talk about the firm’s approach to quality investing, the uncertainty of the market, and the advantages of factoring out low quality stocks instead of simply looking for high quality ones.
Lara Crigger, managing editor, ETF Trends & ETF Database: Can you give us your 30,000-foot view into quality investing?
Sandra Testani, vice president of ETF product and strategy, American Century Investments: Let’s back up, because I think quality, in general, is one of those terms that’s thrown around quite a bit but can have very different definitions.
Crigger: What’s your working definition of “quality?”
Testani: We think of quality not necessarily in the same way that many factor-based investing strategies will do. A lot of the focus is on the fundamentals of a company: profitability, leverage on balance sheets, how variable earnings or sales metrics can be, and so on. But our methodology, particularly for our index-based methodologies, such as VALQ or QINT, tends to be much more comprehensive. We use multiple lenses of how to look at these broad definitions and measure sentiment as a part of quality. We look at whether there have been sell-side upgrades or downgrades, whether there have been earnings surprises, and whether or not there are any governance-related issues in managing the balance sheet.
Another difference is what we do with it within our index strategies. We spend all this time gathering all these fundamental inputs to develop a quality score — which is common, others do that, too — but what we tend to do is use the quality scores to eliminate or filter out stocks, as opposed to concentrating a portfolio around the highest quality. We look to eliminate the exposure to low quality, as opposed to simply focusing on high quality. That insight is probably intuitive: Low quality stocks have historically underperformed, so those are the ones that we try to avoid. That’s our way of ensuring that we’re eliminating these names from the portfolios that have the highest likelihood of eroding value over long periods of time.
Crigger: Do you take the same approach with your active strategies?
Testani: Across our platform we have a lot of fundamentally derived actively managed strategies. So you’ve got individuals, seasoned professionals at the helm, who are picking stocks, and bonds. Naturally, they’re looking to find the most solid, resilient names and avoid the losers. With our more quantitative or systematic strategies, you just don’t have the same level of knowledge or judgement about a company — you’re not meeting with managers, you don’t get that kind of one-on-one insight. So this screening approach helps take out some of that idiosyncratic risk. Then you can build the portfolio from the remainder in a very thoughtful way.
Crigger: In the second half of 2021, quality has been on a bit of a tear, both in terms of advisor interest and in terms of investment flows. What do you think is behind the surge?
Testani: The markets are a bit rudderless with so much friction and competing or conflicting views. That’s led to a lot of these mini-rotations that have occurred over the last 18 months, in that pandemic environment. You have a camp that is very pro-cyclical, risk on, and then another camp that tends to be more concerned about inflation, supply chain issues, or the potential for a more challenging environment in the future.
So I think that having a focus on the higher quality names is a way to help provide a more defensive, more durable approach. You can invest in companies that have the wherewithal to withstand some of the choppiness that we’re expecting moving forward, whether it’s an ability to pass price increases onto their consumers, or in the case of a preferred stock, they have the ability to maintain their dividend throughout the market cycle, even into what could be a more challenging environment in the future.
Crigger: So when you’re looking at quality investing, is there a particular investor for whom it makes more sense than others?
Testani: That’s a really good question. I think, on the face, it’s really hard to say that there isn’t an investor [that couldn’t benefit from quality]. If you look at the historical returns of the highest quality stocks, over time, they have outperformed the market. But there are other factors or characteristics that matter too, including diversification and balance.
We like the idea of investing in quality as a strategic investment. Many of our portfolios consider quality, but quality is paired with something else. So we have quality/growth, quality/value, quality/international. But the basic concept, I think, of eliminating poor performers from the investment universe prior to building the remainder of the portfolio, I think it’s really hard to say that there would be an investor that that doesn’t make a lot of sense for. Somebody who’s really a speculator, I suppose. Somebody who’s a meme stock buyer is probably not going to prioritize that approach. It’s not really possible to take a balance sheet, fundamental lens to something like a cryptocurrency.
Crigger: Looking ahead to 2022, how should advisors be thinking about quality as it factors into their clients’ portfolios? Where does this investment approach make the most sense?
Testani: While we have a very broad platform, I think if you pair this concept with some of the more tactical, forward-looking views, I would say it makes sense across both stocks and bond allocations. For example, instead of a more market cap-oriented approach to international investing, allocating instead into a quality international strategy could make a lot of sense. International stocks tend to have better valuations than U.S. stocks, and the makeup of the marketplace tends to be better aligned with some of the more cyclical sectors. It’s much less exposed to technology and less concentrated. If you just allocate across the market by market cap, then in your developed international portfolio you’ll end up with thousands of names — many of which, if you looked under the hood, you wouldn’t want to own from a fundamental perspective. So I think a quality international allocation makes a lot of sense.
On the fixed income side, in an environment where spreads are relatively tight, yields are relatively low, and there’s rate uncertainty, avoiding the losers in a bond portfolio can be incredibly important, because that’s where they’ll really eat away at your performance. So whether it’s in a multi-sector income type of approach, or preferred stock approach like I mentioned, we strive to make sure that our focus is on developing a portfolio where we can exclude those most likely to be downgraded, and those most likely to have performance degradation.
Crigger: What do you think many advisors and investors are misunderstanding about quality investing?
Testani: In this pandemic market environment, when you drill down and you look at the performance of high quality versus low quality, or high beta versus low beta, so much of the returns of the last 18 months or so has been driven by companies that aren’t the most attractive from a fundamentals perspective. In conversations that I’ve had with advisors, I think many were surprised to see some of the data that just showed from a quality perspective how strong the performance of low quality names had been over the 12 months ending in June/July and how much that drove overall return.
So while that did work, it’s also taking a little bit of a speculative lens to the market — find the most beat-up names and ride a recovery. From a longer-term, more strategic investing perspective, the likelihood of that condition persisting is going to be really challenging.
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