Low volatility and quality are two different, independent investment factors and most factor-based ETFs are only dedicated to one of those concepts. While low volatility and quality are often conflated by investors, most ETFs that blend the two factors do so by incident, not intent.
The FlexShares US Quality Low Volatility Index Fund (NYSE: QLV), which debuted last July, actually emphasize both investment concepts.
QLV follows the Northern Trust US Quality Low Volatility Index. The ETF’s benchmark employs a quality screen to provide exposure to high-quality companies with lower absolute risk, thereby limiting potential future volatility. The quality screen analyzes a broad universe of equities based on key indicators such as profitability, management efficiency, and cash flow, and then excludes the bottom 20% of stocks with the lowest quality score. The index is then subject to regional, sector and risk-factor constraints, in order to manage unintended style factor exposures, significant sector concentration, and high turnover.
“One critique of defensive-equity (low-volatility) strategies is that they’re repackaged versions of two known investment styles: value and profitability,” said Morningstar in a recent note. “That statement implies that defensive strategies are nothing new, and investors should forgo them in favor of others that explicitly target the value and profitability factors.”
The QLV Solution
Quality should not be conflated with low volatility, but there are times when quality stocks display low volatility traits. That was the case during the fourth quarter of last year’s market swoon, indicating that the quality factor can provide some protection during times of elevated market stress.
The core components of the quality scoring model are based on quantitative ranking of various metrics obtained from company filings. These scores consist of three core components: management expertise, profitability and cash flow.
“Low-volatility strategies have had significant but inconsistent exposure to both value and profitability. Therefore, investors who want exposure to these factors are better off with a strategy that explicitly targets those types of stocks,” according to Morningstar. “Those who want to reduce risk should stick with defensive strategies but should not assume they’re directly exposed to value, profitability, or both.”
QLV incorporates strict sector controls to help prevent the index from deviating too significantly from the broader US-equity market. Constructs the final constituents list with consideration to the exposure of the low volatility factor, we believe giving investors a more efficient means of accessing this factor.
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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.