Beware Of Hype On Quality ETFs

February 28, 2019

If you’re an asset allocator concerned about the near-term market environment—slowing global economy, global trade conflicts, Brexit—but want to remain fully invested and avoid timing the markets, while reducing risk, what do you do?

By now, you’ve probably heard plenty of recommendations to flock to high-quality smart beta or tilt your equity exposure toward high-quality names. That seems to be a general consensus call among Wall Street sell-side strategists and institutional asset allocators—to be defensive in equities with high quality, and aggressive in fixed income with high yield. It was also a frequent refrain at the 2019 Inside ETFs conference in mid-February.

This position works if we enter a Goldilocks scenario of low—but positive—real economic growth that keeps the U.S. Federal Reserve on hold from raising interest rates. Such an environment also means growth is “scarce,” which is why one would want to gravitate toward companies that have demonstrable growth and profitability embedded in high-quality smart beta.

Quality also tends to work when corporate earnings are generally positive, but generated during a period of greater uncertainty or headline risks.

By The Time You Hear An Idea, It’s Too Late

On the other hand, one could take a cynical view that the shelf life of an investment idea expires right when it reaches the ETF investor.

After all, the time to hold high quality was in 2018, when it outperformed both the S&P 500 Index and most of the major investment styles (Figure 1), when adjusted for market risk (look at its upside and downside capture throughout the year relative to the other strategies).


Figure 1 – 2018: The Year of ‘Quality’ Outperformance


Like a bad habit, ETF theme promotion tends to focus on what worked last year. However, a reasonable case can still be made for positioning in high quality, if you have a realistic understanding of what exactly the investor is buying, and under what circumstances high quality tends to perform better.

What Is High Quality?

High quality can be defined in many ways: stronger balance sheets, higher returns on capital, higher profitability (i.e., operating margins), more stable earnings and/or better earnings quality (i.e., lower accruals)—basically, buying the companies you’d be proud to own.

There’s still some academic debate on whether high quality should be construed as a risk factor. Why should investors be compensated with extra returns for investing in companies perceived to be safer and more profitable?

Larry Swedroe provides a good summary of this debate in Getting to the Cause of Quality, where he references the Robert Novy-Marx 2012 paper on the gross profitability premium, the primary basis for why Dimensional Funds added profitability to its investable factors (the others being market risk, size, value).

Whether due to structural, behavioral or rational risk-based reasons, there is evidence of excess returns associated with high quality. But there is further debate as to whether the anomaly is driven more by the poor performance of low- quality companies as opposed to the outperformance of high-quality companies. In other words, the excess return associated with high quality may not be symmetrically distributed between high- versus low-quality companies.

Why The Near-Term Shift To Own High Quality?

As seen in Figure 1, what you wanted to own in 2018 was “low or minimum volatility,”’ but this was primarily due to the sharp sell-off in the fourth quarter (you could have also reduced your equity ratio down to 60% or 70% versus bonds, which is about the comparable level of risk offered by low vol).

If you’re generally still concerned about further risk-off volatility like we experienced last quarter, you should simply own fewer equities.

For those concerned about the near-term market environment but want to remain fully-invested, high quality delivers the kind of risk attributes that provide nearly full market participation with less stress. For purposes of this analysis, the iShares Edge MSCI U.S.A. Quality Factor ETF (QUAL) will be used as a proxy for high-quality investing.

And it’s difficult to argue against its attributes: High quality is basically a better-looking version of the S&P 500 Index, and investors don’t need to pay up as much for better quality. Bloomberg data as of Feb. 20 shows that:

Find your next ETF

Reset All