Anchor Equity Portfolios to Quality for Long-Term Results

When investors struggle with high uncertainty or significant volatility, they often search for ways to buttress their portfolios against distress. They could boost their bond allocations at the expense of stocks, but reducing exposure to equities after large selloffs can damage long-term performance.¹  How can investors avoid the urge to sell during down markets to participate in long-term equity-market performance while mitigating risk in their portfolios?

We think anchoring to strong fundamentals is a good start. This means owning companies with plenty of cash flow, high returns on capital and management that avoids overstretching the balance sheet with empire-building. These strong fundamentals define quality — among the so-called equity factors (others include low volatility, which we’ll discuss later, as well as value, momentum, and dividend payers) that academic studies and our research show has outperformed the broad equity market over time.²

Defining Quality

Quality is a challenging equity factor to define. Investment managers who use quality to build their active equity strategies have their proprietary definitions. As an example of metrics we use, a high-quality company within the technology sector looks like this: 

• Annual asset growth: 3%. Low or negative asset growth means the company’s executives are keeping their empire-building—which can load companies with debt—at bay.
• Return on invested capital: 60%. Executives are succesfully turning their capital into profit.
• Free cash flow as a percentage of sales: 25%. The company is profitable on a cash-flow basis and able to turn revenues into free cash flow by managing costs.

In comparison, an example of a company with weak quality characteristics had 15% annual asset growth, 9.7% return on invested capital and 3.7% free cash flow as a percentage of sales. 

A History of Limiting Downside and Strong Upside Participation

Because of strong fundamentals, quality stocks have delivered benefits to investors during volatile markets often associated with market declines. Our research shows that, on average, when markets have fallen, high-quality stocks held up better—limiting losses to 87% of monthly U.S. equity market downturns. Quality also participated in market rallies, capturing 96% of monthly market gains on average.³

Quality has historically captured more in upside markets than it has lost during downside markets, making it an important diversifier for long-term performance. Further, Exhibit 1 shows that quality has outperformed the broad market with slightly less volatility. This reinforces our belief that quality can serve portfolios well throughout cycles, allowing investors to be modestly defensive while still keeping up during the rallies. 

Exhibit 1: A Quality Advantage

The historical ability of high-quality stocks to participate in market rallies and limit losses during market downturns has contributed to outperformance.

^{Source: Northern Trust, Bloomberg. Time period from December 31, 1983, through December 31, 2024. Factor portfolios represent equal-weighted, long-only portfolios of the highest quintile of stocks, based on our quality score, from the Northern Trust Quality Index. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index.}

Quality Plus Low Volatility Can Amplify Stability

As much as quality stocks on their own can fortify an equity portfolio, we find that quality’s true power shines when combined with other equity factors, such as low-volatility stocks.

When markets take a dive—10% or more—it takes real fortitude for some investors to hold steady. This behavioral bias is called loss aversion, which can cause investors to make portfolio decisions during choppy markets that can be very costly.  For investors seeking a greater degree of defense without cutting equity exposure, we find that pairing quality with low-volatility stocks—or stocks with the lowest price volatility—can aid portfolio stability and long-term performance. 

Low-volatility stocks over time have historically limited losses in down markets by about half and participated in 75% of the upside.⁴  Exhibit 2 shows how a 50/50 quality/low-volatility portfolio also outperformed the broad market, with lower volatility than the broad market and Exhibit 1’s quality-only portfolio.

Exhibit 2: A Quality-Low Volatility Blend for the Risk Averse 

Adding low-volatility stocks to a quality portfolio can reduce risk while still outperforming the market.

^{Source: Northern Trust, Bloomberg. Time period from December 31, 1983, to December 31, 2024. The high quality-low volatility combination represents a 50/50 combination of capitalization-weighted portfolios of the highest quality stocks, based on our quality score from the Northern Trust Quality Index, and lowest volatility stocks, based on the Barra’s multi-factor risk model for equities. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index.}

Anchor Portfolios to Better Navigate Market Uncertainty

No investor can predict when volatility will strike or when sudden rallies will occur. However, we believe a well-designed portfolio anchored in quality—and, for more risk-averse investors, quality combined with low-volatility stocks—can prove a useful tool to navigate the spectrum of market conditions through the market cycle. 

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Glossary

Assets: Assets on a company's balance sheet are resources controlled by an enterprise from which future economic benefits to the enterprise are expected to flow.

Barra multi-factor risk model: The model computes an asset's sensitivities to industry groups, market characteristics and fundamental data.

Free cash flow: Free cash flow is cash that would be available to a company’s investors after the company has made all investments necessary to maintain the company as an ongoing enterprise.

Return on invested capital: Return on invested capital is after-tax profitability of capital invested by a company’s shareholders and debt holders.

Russell 1000 Index: The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe.
 

^{1 Source: Northern Trust, Bloomberg. From 2009 to 2024, missing the largest five daily gains in the Russell 1000 Index reduced the cumulative return on a $100 initial investment to $611 from $890 for all days, a 31% decrease. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Indexes are the property of their respective owners, all rights reserved.}

^{2 See Foundations in Factors, Northern Trust, 2024}

^{3 Source: Northern Trust, FTSE-Russell. Data from December 31, 1983 to December 31, 2024. To create the portfolio of quality equity companies, we used the top quintile of stocks in the Northern Trust Quality Index based on our quality score. Upside market capture is, during months when the Russell 1000 Index return is positive, the average monthly return of quality equities divided by the average monthly return of the Russell 1000 Index. Downside capture is, during months when the Russell 1000 return is negative, the average monthly return of quality equities divided by the average monthly Russell 1000 return.} 

^{4 Source: Northern Trust, FTSE-Russell, Barra. Time period from December 31, 1983, to December 31, 2024. To create the portfolio of low volatility stocks, we used the Barra multi-factor risk model for equities. Upside market capture is, during months when the Russell 1000 return is positive, the average monthly return of low volatility equities divided by the average monthly return of the Russell 1000 Index. Downside capture is, during months when the Russell 1000 return is negative, the average monthly return of low volatility equities divided by the average monthly Russell 1000 return.}

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