Best Positioning with Factor-Specific ETFs

As investors craft a portfolio for the current market environment, some may turn to factor-specific ETFs to target themes that could pop up ahead.

For instance, the quality factor has been a prominent investment theme that has outperformed over the years, and it may continue to do so.

“This factor has been outperforming the broad market, to a lesser degree, for the past 10 years,” OppenheimerFund’s David Mazza and Sam O’Connell wrote in a research note. “The underlying reasons for this outperformance offers insight into what constitutes quality today, and they also provide an indication of where investors looking to incorporate factor tilts into their portfolios may want to add exposure.”

Investors usually gain exposure to quality through defined metric such as corporate profitability, operational efficiency, earnings quality, and financial leverage.

Last year, the quality factor outperformed the broader market by 638 basis points, which was surprising as the year was dominated by growth names and the factor has been associated with outperformance in periods of economic slowdowns.

However, the quality factor index now includes a healthy dose of information technology names, which may have contributed to the outperformance of the factor in 2017. While many think of information technolgoy as a traditional growth sector, these same companies have recently offered a high return on equity, strong profit margins, and low debt-to-equity ratios, which are all quality traits.

Consequently, the quality and momentum factors may be more correlated in recent years.