Vanneman: 'Quality' Through ETFs

February 24, 2014

Who doesn’t love the idea of buying ‘high quality’ securities?

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Rusty Vanneman, chief investment officer of Omaha, Neb.-based CLS Investments.

While the “quality” label has been easy to throw around in the past, it has only been in recent years that academics and investment professionals have worked hard to articulate how “high quality” is defined—and what it means for investors.

Quality, much like beauty, is often defined in the eye—or the spreadsheet—of the beholder, but common characteristics of high-quality stocks include higher and more consistent profitability, stronger balance sheets (i.e., less debt), and higher dividend growth.

The good news is there is a plethora of exchange-traded funds that access “quality” in a variety of ways, including the iShares MSCI USA Quality Factor (QUAL | A-68) in the domestic space, and WisdomTree’s Global ex-US Dividend Growth Fund (DNL | D-58) for those looking to diversify internationally in a more granular manner.

As for what buying stocks with these characteristics means for investors, historically, it has provided superior returns, both on a total return and risk-adjusted basis.

Various studies on this topic have been published in recent years:

  • One study, Novy-Marx’s 2012 “The Other Side of Value: The Gross Profitability Premium,” showed that profitable firms generated significantly higher returns despite having higher valuation ratios.
  • The 2013 paper from Asness, Frazzini and Pederson, “Quality Minus Junk,” also revealed that while high-quality companies do tend to trade at premiums, the market still does not pay enough for them. Since 1951, high-quality stocks have significantly outperformed.

These studies, however, focused on quality U.S. stocks.

What about globally? Does the quality factor also work in international markets?

According to a few more recent papers, the answer appears to be yes.

  • The Kozlov and Petajisto paper published in 2013, “Global Return Premiums on Earnings Quality, Value, and Size,” confirmed that a global portfolio consisting of long stocks with high earnings quality and short low earnings quality produced a higher Sharpe ratio than the overall market.
  • In addition, in a late 2013 Pimco paper by Gordon and De Rossi, “The Profitability Premium in EM Equities,” Pimco showed that profitability tends to be persistent and underpriced. There is a profitability premium for investors to capture.

The idea of applying high-quality factors to international ETFs is relatively new.

As a result, not many ETFs are fully established yet, meaning trading volumes and liquidity aren’t as developed as their domestic equity cousins. Nonetheless, as I noted, many ETFs are attractive. Here are some ETFs that CLS Investments currently uses in various portfolios:

 

 

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