Quality was one of the best-performing investment factors last year and, as highlighted by the Invesco S&P 500 Quality ETF (NYSEArca: SPHQ), the oft-overlooked factor is off to a strong start in 2020.
SPHQ seeks to track the investment results of the S&P 500 Quality Index. In selecting constituent securities for the underlying index, the index provider calculates the quality score of each security in the S&P 500 Index, then selects the 100 stocks with the highest quality score for inclusion in the underlying index.
The quality factor is a point of emphasis for a growing number of strategic beta ETFs. Though there has been debate surrounding defining quality as it pertains to factor-based investing, quality companies and dividend-paying stocks often go hand-in-hand because those dividends are seen as signs of stable earnings and thoughtful management.
“Because of this, it’s standing as the best-performing factor in 2019 comes as no surprise,” said S&P Dow Jones Indices in a recent note. “Quality, on the other hand, is a frequently debated factor for which definitions can vary greatly and performance can be cyclical. Therefore, its outperformance in 2019 merits additional insight and analysis.”
Quality has historically outperformed other investment factors during economic slowdowns, but that thesis could be challenged if quality ETFs amass large positions in cyclical sectors, such as tech.
The $1.87 billion SPHQ holds 100 stocks, over 35% of which hail from the technology sector. The healthcare and industrial sectors combine for over 34% of the fund’s weight.
“Given that the S&P 500 High Quality Index comprises three fundamental ratios, we sought to understand which ratio contributed the most to the index returns,” according to S&P Dow Jones. “The market rewarded profitable companies handsomely in 2019. ROE was the best-performing ratio of the three (38.2%), followed by accruals (29.8%), and then leverage (28.1%). In fact, the portfolio of the highest ROE companies outperformed the S&P 500 by nearly 670 bps.”
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Historical data confirm that the quality factor wins over the long-term as the most profitable companies have easily outpaced their less profitable peers by significant margins over longer holding periods.
“In sum, 2019 was a strong year for domestic equities. The S&P 500, a market barometer for large-cap U.S. equities, posted its second-best year in a decade,” notes S&P Dow Jones. “Quality was one of the few factors that managed to deliver higher returns than the S&P 500. Upon deeper examination, we found that profitability was the biggest return contributor to the quality factor, posting significantly higher returns than the S&P 500. While it may seem like 2019 was a difficult period to beat the S&P 500, our blog highlights that passive factor strategies with exposure to quality performed even better than the S&P 500 in 2019.”
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.