Smart Beta ETFs: Analyzing the Quality Factor

Quality is one of many factors helping propel the investment case for smart beta ETFs that eschew traditional market cap-weighted indexing methodologies.

But what exactly is this quality factor?

“Definitions for quality vary across the industry. Here at Deutsche Asset Management, in partnership with FTSE Russell, we define quality in terms of profitability and leverage,” writes Eric Legunn, ETF Strategist for Deutsche Asset Management, in a research note.

Specifically, the quality factor tries to identify companies that exhibit persistent profitability and low leverage in every type of economic market environment.

When looking at a firm’s profitability and its ability to persist, investors should consider three metrics, including return on assets, changes in asset turnover and accruals.

Profitability measures the efficiency of a business in terms of how well it can produce a return on investment. Consequently, an observer would look at a company’s ROA to gauge profitability as it is calculated by dividing net income by total assets and measures how well a firm deploys its assets to generate earnings, so those with higher ROAs are considered more profitable.

Asset turnover covers a company’s sales relative to its asset base, measuring a firm’s efficiency by calculating how many dollars of sales are generated per dollar of assets. A rising ratio of this measure would indicate a company that is improving its efficiency or raising its profitability.