Exchange traded fund investors should consider the benefits of the quality factor and how a quality investment strategy can enhance and diversify investment portfolios.
In the recent webcast, Focus on Quality to Navigate Changing Markets, Samantha Azzarello, Executive Director, Global Market Strategist, J.P. Morgan Asset Management, outlined the current state of our weakened economy after the coronavirus pandemic took a blow to normal activities. Civilian unemployment rates remain elevated at around 10%, compared to the 50-year average of 6.2%. High-frequency economic activities have also declined on a year-over-year basis, but they have improved since the March lows. The U.S. Purchasing Managers’ Index for services has rebounded to 55.0, a sign that business activity is expanding.
Meanwhile, U.S. markets have staged a strong rally, one of their quickest recoveries from a recession to date. However, the markets look pricey, with the S&P 500 trading at a forward price-to-earnings of 22.5x, compared to 19.0x before the Covid-19 panic selling and a 25-year average of 16.5x.
While market pullbacks may seem nerve-racking, the volatility is still part of the normal market behavior. In the past 40 years, the S&P 500 Index experienced an average intra-year drop of 13.8%, but the benchmark still showed annual positive returns in 30 of those years.
“The speed at which the S&P 500 entered bear market territory, the speed at which it recovered, and the levels of concentration in top stocks have all never been seen before,” Josh Rogers, Investment Specialist, Beta Strategies, J.P. Morgan Asset Management, said.
Rogers also highlighted the top-heavy nature of traditional market cap-weighted indices, notably the S&P 500, where the concentration of its top 5 holdings make up 23.7% of the total portfolio. This top-heavy exposure also reflects the best performers within the index, but this also means that investors could suffer unintended risks since they are now heavily exposed to the pricier companies with some of the highest valuations.
Alternatively, Rogers highlighted a quality factor ETF indexing strategy, the J.P. Morgan U.S. Quality Factor ETF (NYSEArca: JQUA), that can help investors shift to quality or companies with healthy balance sheets and strong cash flows.
The J.P. Morgan U.S. Quality Factor ETF is designed to reflect the performance of the J.P. Morgan U.S. Quality Index, which is comprised of U.S. securities included in the Russell 1000 Index and selects constituents based on their quality as measured by profitability, solvency, and earnings quality. The profitability component screens for companies with strong earnings, cash flow, and profits. Financial solvency screen singles out those with low leverage, high-interest coverage, or low share price volatility. Lastly, earnings quality includes companies with consistent earnings quality via accounting measures like accruals.
JQUA could help investors generate improved risk-adjusted returns over time. Specifically, the quality factor ETF has generated an annual return of 9.75% since its inception with a volatility of 27.77% and a Sharpe Ratio of 0.37%. In comparison, the Russell 1000 showed a lower annual return of 9.09%, a higher volatility of 28.87%, and a lower Sharpe Ratio of 0.32 in the same period. The quality screens have also helped JQUA suffer lower drawdowns, such as an improved 1.7 percentage point drawdown compared to the Russell 1000 in the most recent coronavirus-induced selling.
“Despite the concentration of US market returns this year, we believe breadth will be important looking forward,” Rogers added. “JQUA has profitable stocks that are most able to repay their debt, even if market stressors reemerge. Quality stocks in every sector can be accessed through JQUA at a fee of just 12bps.”
Financial advisors who are interested in learning more about the quality market factor can watch the webcast here on demand.