The quality factor is generating renewed attention as of late, leading to an important reminder about a couple of things. First, investing for quality is usually a durable strategy that serves long-term investors well.
Second, there remains fluidity in how market participants, including index providers and fund issuers, define quality, and those differences are meaningful to end users.
Investors seeking a straight forward approach to quality with a compelling dividend stream may want to consider the WisdomTree US Quality Dividend Growth Fund (DGRW). The $6.48 billion DGRW tracks the WisdomTree U.S. Quality Dividend Growth Index and employs criteria such as return on equity (ROE) and return on assets (ROA) in its security selection process. DGRW’s ROE emphasis is rewarding for investors.
“Academic research shows that a very simple sort of the market by a profitability metric known as return on equity (ROE) has delivered strong long-term returns,” said WisdomTree Global Head of Research Jeremy Schwartz in a recent note. “The return spread between the highest and lowest ROE companies has been approximately 4% a year going back almost 60 years.”
Indeed, there are times when lower-quality names, including bad and negative ROE companies, lead. That was seen earlier this year when some junkier stocks led value higher. As a result, DGRW is trailing the S&P 500 Value Index by 150 basis points on a year-to-date basis. However, quality wins out over longer holding periods. DGRW beat the the S&P 500 Value Index by 1,370 basis points with lower annualized volatility for the three years ending Aug. 23.
“Looking over more recent history, we see over the last 15 years that high-ROE stocks have even expanded their lead over low and negative ROE stocks. But over the last year, there has been a large ‘junk rally’ taking place, with the market propelled by firms with negative ROE or the lowest ROE,” adds Schwartz.
Adding to the DGRW case is that 78% of the members of the WisdomTree U.S. Quality Dividend Growth Index reside in the two highest ROE quintiles, which, as Schwartz points out, is 24% above the level for the S&P 500.
At the sector level, technology and healthcare are two of the more desirable quality destinations while energy, real estate, and utilities are often littered with lower-quality fare. To that end, tech and healthcare combine for over 46% of DGRW’s weight while the other three segments represent just over 2% of the lineup.
“Overall, we believe that there is an opportunity in the current quality market that should not be overlooked. Markets may have dislocated from longer-term quality trends over the past year, but we think they’ll restore their preference for higher-quality companies soon,” concludes Schwartz.
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