The quality factor and related exchange traded funds are once again strutting their stuff, but for investors considering these instruments, it’s important to understand what makes them tick.
The Invesco S&P 500 Quality ETF (NYSEArca: SPHQ) is a popular ETF in this category. SPHQ seeks to track the investment results of the S&P 500 Quality Index. In selecting constituent securities for the underlying index, the index provider calculates the quality score of each security in the S&P 500 Index, then selects the 100 stocks with the highest quality score for inclusion in the underlying index.
Perhaps not surprisingly, technology stocks figure prominently into the quality equation and SPHQ bears that out with a nearly 38% weight to the sector.
“Sectors and factors are different ways of viewing the world, but they are not mutually exclusive. We find an example of such a close, symbiotic relationship between the technology sector and the quality factor,” notes S&P Dow Jones Indices.
Why Quality Matters
Quality has historically outperformed other investment factors during economic slowdowns, but that thesis could be challenged if quality ETFs amass large positions in cyclical sectors, such as tech.
“Both technology and quality have outperformed during both calendar 2020 and the 12 months ending April 30. This raises an obvious question: Has technology done well because of its exposure to quality, or has quality done well because of its exposure to technology?,” ponders S&P Dow Jones.
Historical data confirm that the quality factor wins over the long-term as the most profitable companies have easily outpaced their less profitable peers by significant margins over longer holding periods. SPHQ’s benefits are on display this year.
What’s interesting regarding SPHQ’s technology weight is that quality appears to have more influence on technology, not the other way around.
“While the five largest names in Info-Tech are all in the top quality quintile, only three out of the five largest names in the top quality quintile are in Technology, further confirming our conclusion that quality’s influence on technology outweighs technology’s influence on quality,” according to S&P Dow Jones.
Healthcare, another high quality group, is SPHQ’s second-largest sector weight. Combined with technology, the sectors represent nearly two-thirds of SPHQ’s roster. That’s likely one reason why the Invesco fund is beating the S&P 500 by more than 200 basis points this year.
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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.