It would be hard to argue against owning high-quality stocks.
How could an equity investor go wrong by holding top-quality names with strong fundamentals, companies that should be able to better navigate a market storm thanks to strong balance sheets, low levels of debt, and consistent, sustainable—and growing—profitability?
The theory and the academic research behind quality equity ETFs show they are designed to offer just that—relative outperformance relative to the broad market while mitigating downside risk in times of trouble. But that’s not always the case, for two key reasons.
First, quality is a factor. It’s a driver of returns, much like momentum, value and low volatility. That means quality, too, is susceptible to periods of underperformance. No single factor outperforms the market all of the time.
Secondly, as with everything else in the ETF market, the key to a passive quality ETF is its underlying index. And when it comes to quality equity indexes, there are no two alike. Methodologies vary significantly. That translates to performance disparity.
There are at least 85 equity ETFs on the market today that in one way or another look for quality companies. The segment is broad, with a varied mix of strategies. But consider two funds as a sample of the differences you could find in this space:
- iShares Edge MSCI USA Quality Factor ETF (QUAL), with $3.06 billion in assets and a 0.15% expense ratio.
- VanEck Vectors Morningstar Wide Moat ETF (MOAT), with $735 million in assets and a 0.49% expense ratio.
Here’s how they’ve performed this year relative to the SPDR S&P 500 ETF (SPY):
QUAL, the largest ETF here, and a hugely popular one, raking in some $1.2 billion in fresh net assets so far in 2016, has been underperforming SPY by almost 2 percentage points.
Outperforming MOAT Sees Outflows
The fund is also under-delivering relative to competing MOAT by some 10 percentage points.
MOAT, the much smaller ETF that has actually seen net redemptions this year totaling $58 million thus far, has outperformed both QUAL and SPY by more than 9 percentage points each.
Both of these ETFs are considered funds that focus on top-quality companies, but their returns are vastly different, and here’s why:
QUAL picks stocks based on three fundamental metrics—return on equity, earnings variability and debt-to-equity—according to iShares, and then fundamentally weights them. The fund in the end owns 124 securities selected and weighted by fundamentals of quality, making it three times as large—broader and more diverse—than MOAT, which today has 44 holdings.
MOAT, meanwhile, is a value strategy at heart. It picks stocks with the lowest price to fair value ratio among firms with a sustainable competitive advantage, according to VanEck. The fund then equally weights these stocks, assigning them equal impact on portfolio returns. And this year, that value focus did well relative to the broad market.