Beware Of Hype On Quality ETFs

February 28, 2019

  • QUAL has a better balance sheet profile judging by credit rating exposure (Moody’s and Standard & Poor’s). On a portfolio-weighted basis, QUAL has 24%/23% exposure to Baa/BBB-rated and below companies versus 33%/32% for the S&P 500.
  • The near-term earnings picture for QUAL’s tracking benchmark, MSCI USA Quality Index, has not deteriorated as much as the S&P 500 Index (Figure 2).
  • QUAL trades at 17.2x estimated 12-month earnings per share, based on Bloomberg consensus estimates—not much higher than the 16.2x for the S&P 500, even though QUAL has a higher projected ROE versus the S&P 500.
  • In addition, despite its strong relative performance in 2018 and consensus popularity, relative valuations do not look extended when compared to recent history. So, high quality doesn’t look “crowded” from a sentiment or valuation standpoint.
  • QUAL’s dividend yield is just under 2%, or about the same as the S&P 500.

 

Figure 2 – The Earnings Picture for High Quality (Pink) Has Not Deteriorated as Much vs. the S&P 500 (White)

Source: Bloomberg using Bloomberg Consensus Earnings Estimates for the 1-Year Period Ending 2/20/2019

 

Figure 3 displays the Bloomberg risk model profile of QUAL versus the S&P 500 Index (using the SPDR S&P 500 ETF (SPY) as a proxy). Some points worth highlighting:

  • The market risk, or beta, is 0.98, so QUAL has a similar market to that of the S&P 500. Investors are not giving up market risk to achieve higher quality.
  • QUAL is projected to exhibit 2% tracking error (or +/- 2% return deviation from the S&P over the next year).
  • Most of the projected tracking error can be sourced to positive exposure to global profitability (GL profit), Bloomberg’s risk factor designed to capture the spread between high- versus low-profitable companies. This shouldn’t be a surprise, since quality tends to be most directly associated with profitability.
  • Keep in mind that QUAL is constructed to have similar sector weightings versus a market-cap-weighted portfolio, so sector risk is not a significant contributor to overall tracking error.

 

Figure 3 – QUAL’s Active Risk Profile vs. the S&P 500 Primarily Driven by Positive Exposure to Profitability

Source: Bloomberg Global Risk Model

 

Hence, QUAL essentially provides participation in high versus low profitability, similar to the factor described in the 2012 Novy-Marx paper. Bloomberg’s Pure Profitability (“BPP”) factor used in its Global Risk Model is a useful proxy for capturing profitability, but should not be considered as investable, since it assumes full shorting with no transaction costs.

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