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.
The accruals aspect tries to capture the historical accrual anomaly of a negative relationship between account accruals and stock returns. Academic studies reveal earnings attributed to accruals show lower persistence than earnings attributed to cash received. The quality factor would then underweight those with high accruals.
Related: Factor Focus With Deutsche Smart Beta ETF
Meanwhile, when assessing a firm’s level of leverage, an investor would measure the characteristic by using a ratio of operating cash flow to total debt. Low levels of cash flow to debt have historically exhibited a strong relationship of business failure, and companies that have high leverage face greater risk of default. Furthermore, historical data show increased leverage is usually associated with lower future profitability.
“Overall, the quality factor captures detailed information about companies and aims to enhance investor returns by tilting portfolios towards stocks that rank well from both a profitability and leverage standpoint. We seek out companies that earn more dollars of net income per dollar of assets, squeeze more sales from their assets this year than last, report high quality earnings, and use relatively less leverage,” Legunn said.
Potential investors interested in accessing this quality factor may look to a number of smart beta ETF strategies as a way to potentially enhance equity exposure through a transparent and rules-based process and focus on the best companies in the market. For instance, investors may consider the Deutsche X-trackers Russell 1000 Comprehensive Factor ETF (NYSEArca: DEUS), Deutsche X-trackers Russell 2000 Comprehensive Factor ETF (NYSEArca: DESC), Deutsche X-trackers FTSE Developed ex US Comprehensive Factor ETF (NYSEArca: DEEF) and Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF (NYSEArca: DEMG), which combine five single factors into a multi-factor strategy, including value, size, momentum, low volatility and quality.
For more on Smart Beta ETFs, visit the Smart Beta Channel home page.