It may not get the attention that the growth, low volatility and value factors get, but the quality factor is a useful way for investors to identify financially sound companies. Some exchange traded funds focus directly on the quality factor, including the iShares Edge MSCI USA Quality Factor ETF (Cboe: QUAL).
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.
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.
QUAL “targets large- and mid-cap U.S. stocks with the best profitability (measured by return on equity), strongest balance sheets, and most-consistent earnings growth within each sector,” said Morningstar. “These stocks often carry above-average valuations, and because the fund does not impose a valuation discipline, it tends to exhibit a growth tilt.”
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.
“The types of stocks the fund favors have tended to hold up a little better than average in market downturns,” according to Morningstar. “Their competitive advantages help protect profits and should make them slightly less sensitive to the business cycle than less-advantaged firms. For instance, during the bear market from late 2007 through early 2009, the fund’s index cumulatively lost 47.0%, while the MSCI USA Index lost 54.7%.”
The $4.35 billion QUAL holds 125 stocks. QUAL allocates over a quarter of its weight to the technology sector and 28% of its combined weight to the financial services and healthcare stocks. The ETF is up 2% year-to-date.
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