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.
At FTSE Russell, the quality score is calculated by using a 50% emphasis on profitability, which is subdivided into equal 33% portions of ROA, CTO, and ACCR, along with a 50% emphasis on leverage. Consequently, in a an index with a quality factor screen, companies that exhibit the highest quality scores are more heavily weighted in a portfolio that aims to capture the quality factor, while companies that exhibit the lowest quality scores are least heavily weighted.
Consequently, when gaining exposure to the quality factor, there are basic considerations to check through before gaining exposure to a company.
“Which company is more profitable? Which company has less debt relative to the size of its cash flow stream? Which company is more efficiently generating sales from its assets over time? These questions change the way in which we compare Company X and Company Y,” Legunn said.
Luckily for ETF investors, one does not need to individually go through each U.S. company stock and calculate these various considerations to come up with a list of quality names. Instead, an ETF investor may consider smart beta ETFs that incorporate the quality factor.
For example, Deutsche Asset Management offers a Comprehensive Factor ETF suite, including Deutsche X-trackers Russell 1000 Comprehensive Factor ETF (NYSEArca: DEUS), Deutsche X-trackers FTSE Developed ex US Comprehensive Factor ETF (NYSEArca: DEEF), Deutsche X-trackers Russell 2000 Comprehensive Factor ETF (NYSEArca: DESC) and Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF (NYSEArca: DEMG). The Duetsche X-trackers multi-factor suite selects components based on a broader five factors, including quality, value, momentum, low volatility and size. The multi-factor approach also helps limit potential risks of focusing on any single factor as the various market factors may perform differently during various market conditions.
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