A Closer Look at the Quality Factor in Smart Beta ETFs

Quality has been an outperforming market factor, helping investors garner enhanced market returns, but how exactly do smart beta ETFs hone in on “quality” companies?

“Year-to-date the Russell 1000 Quality Factor Total Return Index has outperformed not only the Russell 1000 Total Return Index, but also the Russell 1000 Value, Size, Volatility and Momentum Factor Total Return Indexes. This is a noteworthy result that deserves attention,” Eric Legunn, ETF Strategist for Deutsche Asset Management, said in a research note.

But what exactly is quality? At Deutsche Asset Management and FTSE Russell, they define the quality factor in terms of high and persistent profitability, along with low leverage.

When looking at the company profitability, the quality factor scrutinizes a company’s return on assets (ROA), change in asset turnover (CTO), and level of accruals (ACCR).

“These three metrics gauge both the level and persistence of a company’s profitability,” Legunn said.

Additionally, a ratio of operating cash flow to total debt is used to assess a company’s leverage.