As valuations grow uncomfortably high, ‘quality’ ETFs make more sense—if you can figure out just what quality means.
Many investing pundits are singing the same song: Equity valuations are high, supported in part by a slowly recovering economy but mostly by central banks propping up markets here and abroad.
In plainer terms, stock prices are higher than they have a right to be, making some investors nervous.
Those who feel this way have often turned to value ETFs. Value funds explicitly target cheaper stocks by comparing share prices to earnings and to the book value of equity. The catch with this approach is this: What if many or even most stocks are overpriced—a notion that’s consistent with the broad and massive central bank action—and what if the few stocks that are cheap deserve to be?
In this context, and in theory at least, “quality” ETFs seem like a reasonable answer.
Unlike value ETFs, quality ETFs leave share price out of the equation. Instead, they focus on balance sheet metrics like earnings, cash flow and dividends, and don’t scale these numbers by share price. The quality approach helps investors avoid the value trap by steering clear of stocks that are “cheap for a reason.” In short, quality ETFs hold the promise of holding a basket of stocks that are supported by sound fundamentals—a sober antidote to a frothy punch bowl of cap-weighted stocks.
One challenge of taking the high road to quality stocks is the lack of consensus as to what quality means. ETFs—or, more accurately, the indexes they track—define quality as they see fit. Nothing shows this better than comparing the portfolios head-to-head.
For the iShares MSCI USA Quality Factor (QUAL | A-78), Apple, Microsoft and Google take the top spots, and tech names take five of the top 10. Sector concentrations are stark: QUAL takes a huge stake in tech and all but ignores financial stocks.
Compare this with another quality-oriented fund, the FlexShares Quality Dividend ETF (QDF | B-73). While Apple still takes the top spot, QDF leans away from tech firms and favors financials and energy stocks.