After delivering impressive performances last year, the quality factor is at it again this year, giving rise to ETFs, such as the FlexShares US Quality Low Volatility Index Fund (NYSE: QLV).
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 the regional, sector, and risk-factor constraints, in order to manage unintended style factor exposures, significant sector concentration, and high turnover.
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 March market swoon, indicating that the quality factor can provide some protection during times of elevated market stress. QLV’s ability to blend both factors is a potential advantage for investors.
Call on QLV
The low-volatility factor investments work on the idea that they help cushion against market turns, limiting drawdowns that investors experience while providing upside potential. Consequently, the low- or min-vol strategies may produce better risk-adjusted returns over the long haul, which has been backed by extensive academic research.
There are multiple ways of defining quality, making it somewhat misunderstood relative to rival factors, such as value and low volatility. However, there are some hallmarks of quality that usually easy to identify.
The core components of the quality scoring model are based on the quantitative ranking of various metrics obtained from company filings. These scores consist of three core components: management expertise, profitability, and cash flow.
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.
Investors may also find that the quality low-volatility index strategies, including QLV, also exhibit lower drawdowns and upside potential compared to indexing methodologies that only focus on low volatility or minimum volatility.
QLV, which celebrates its first anniversary in a couple of months, holds 137 stocks, 22.15% of which hail from the technology sector.
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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.