When equity market volatility rises, investors thinking about getting defensive with sectors such as consumer staples, real estate and utilities. The problem with that strategy in the current environment is that those sectors are historically laggards when interest rates are rising.
Investors can deploy quality strategies to gain some defense without depending heavily on rate-sensitive sectors. Exchange traded funds such as the iShares Edge MSCI USA Quality Factor ETF (Cboe: QUAL) can help with that objective.
Valuing high quality value is particularly important as bull markets enter their waning stages, as some market observers believe the current bull market is doing. In the early stages of bull markets, lower quality companies see their shares soar. However, as the bull matures, investors often exhibit a preference for higher quality fare with more compelling valuations.
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“Investors may be tempted to add to bond proxies and related defensive stocks as their premium valuations to the rest of the market have lessened,” said BlackRock in a note out Thursday. “Yet the nominal and real rate backdrop may well warrant this relative multiple compression. We find some of these companies, in fact, have been unable to increase cash flows—even against an economic backdrop where profitability has reached new highs for most of the market.”
What Makes QUAL Unique
QUAL, which is nearly five years old, “seeks to track the investment results of an index that measures the performance of U.S. large- and mid-capitalization stocks as identified through three fundamental variables: return on equity, earnings variability and debt-to-equity,” according to iShares.
QUAL holds 125 stocks and allocates over a quarter of its weight to technology names. The financial services and consumer discretionary sectors combine for almost 28 percent of the ETF’s weight. Technology and financials are among the sectors that often perform well as rates rise.
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“Quality companies, by our definition, are those able to generate and grow free cash flow while maintaining healthy balance sheets,” said BlackRock. “Companies with the fundamental ability—and demonstrated willingness—to increase dividend payouts appear better positioned to offer portfolio protection than those with only high dividend yields.”
Quality stocks can also be less volatile than the broader market. For example, QUAL’s three-year standard deviation of 9.76% is slightly below that of the S&P 500.
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