The quality factor and related ETFs have been receiving increased attention this year. One fund that merits more consideration in that conversation is the FlexShares US Quality Large Cap Index Fund (CBOE: QLC).

QLC selects and weights companies based on management efficiency, profitability, and cash flow to determine quality, according to FlexShares. Management efficiency is a quantitative evaluation of a firm’s deployment of capital and its financing decision. Profitability scores help weed out firms with wider margins, which may be better positioned to grow. Lastly, cash flow signals the liquidity level of a company. Those with higher cash flows may be better situated to take advantage of potential opportunities or enjoy a financial cushion in downturns.

The ETF follows the Northern Trust Quality Large Cap Index, which “is designed to measure the performance of a universe of large-capitalization securities which demonstrate characteristics of better quality, attractive valuation and positive momentum,” according to the issuer.

Important To Value High Quality

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.

QLC skirts value traps by including momentum characteristics, which will be determined through a stock’s price history to capture a picture of the recent performance and by using analysts analyst outlooks to get a sense of future sentiment regarding a company. About half of QLC’s holdings are classified as value stocks.

QLC will also have a value focus, which is calculated through various valuations metrics, such as recent earnings report to calculate price-to-earnings, the Shiller’s CAPE or cyclically adjusted P/E, and analysts estimated futures earnings.

Value stocks usually trade at lower prices relative to fundamental measures of value, like earnings and the book value of assets. On the other hand, growth-oriented stocks tend to run at higher valuations since investors expect the rapid growth in those company measures, but more are growing wary of high valuations.

For more on smart beta ETFs, visit our Smart Beta 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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