This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by John Davi, chief executive officer and chief investment officer of Astoria Portfolio Advisors in New York City.
This isn't the time in the cycle to take excessive risk. The easy money has already been made. Late-cycle economic forces combined with desynchronized global growth and a deteriorating earnings cycle means you need more defensive posturing across stocks and bonds.
We’ve long called for owning higher-quality stocks in 2019. Why? Companies with above-average return on equity (ROE)/return on assets (ROA), and with increasing or stable profitability should be rewarded more when earnings are declining.
Secondly, higher-quality stocks have historically outperformed lower-quality stocks (see chart below).
Source: Kenneth French Data Library, with data as of 12/31/17, WisdomTree.
Since 1963, the highest quintile of U.S. profitable companies has returned 11.63%, while the lowest quintile has returned 7.79%. Higher-quality companies have outperformed the market over this same time period as the market returned 10.30%.
Why Quality, Why Now
We’ve been looking for quality ETFs to take in more assets than any other factor in 2019, and year-to-date, U.S.-listed quality ETFs have already taken in approximately $2 billion in assets as of early February. Consider that the entire equity ETF universe has seen approximately $20 billion of outflows in 2019.
We like high-quality stock ETFs for the following reasons:
The earnings cycle is deteriorating, and companies with above-average ROE and increasing profitability are likely to be rewarded more on a relative basis.
The quality factor historically has been shown to be robust, pervasive and persistent over time.
Over the past five years, the global economy has had varying periods of acceleration and slowdowns, but the general trend has been cyclicals outperforming defensives.
Given the late-cycle economic pressures and a deteriorating earnings environment, defensive companies with higher-quality attributes will be rewarded more in 2019. If high-quality stocks performed well when the market was driven by QE and led by cyclicals, why wouldn’t quality work when the market shifts to a more defensive tone?
The quality factor is intuitive (i.e., it’s easy to understand), persistent (works across time class) and is pervasive (works across asset class).
Quality ETFs Not Created Equal
There are several quality ETFs investors can choose from, and more importantly, several differences among them.
Broadly speaking, you are looking for a portfolio of stocks that have demonstrated the ability to consistently grow or keep their earnings stable regardless of the prevailing macro conditions.
We find that the WisdomTree US Quality Dividend Growth Fund (DGRW) and the iShares Edge MSCI U.S.A. Quality Factor ETF (QUAL) have relatively higher factor loadings and have more balanced sector weights compared with some of the other larger quality ETFs.
Both DGRW and QUAL have outperformed the S&P 500 over the past five years despite the quantitative easing-induced rally. Compared with other large quality ETFs, such as the FlexShares Quality Dividend Index Fund (QDF) and the Invesco S&P 500 Quality ETF (SPHQ), QUAL and DGRW have done notably better since July 2013 due to different methodologies.
Looking Under The Hood Is Key
As chief investment officer of Astoria, I have spent 20 years in the ETF ecosphere doing portfolio construction research, analyzing ETFs and structuring portfolios for investors. Picking the right quality ETF isn’t a trivial task, and I see a lot of mistakes when investors select ETFs.
Among the two largest quality ETFs, DGRW provides a slightly higher factor loading (robust minus weak (RMW), which is a profitability premium) compared with QUAL.
Data Source: PortfolioVisualizer.com. (RMW) Robust Minus Weak: The profitability premium. Data retrieved on 2/7/2019.
Below is a table showing the five factor loadings for the larger quality ETFs. (You can see a description of each of these factors here.)
Data source: Portfolio Visualizer. Data for DGRW, QUAL, QDF, SPHQ, and QDEF is based on the time period August 2013 through December 2018. Data for OUSA and FQAL is based on the time period October 2016 through December 2018.
Comparing DGRW & QUAL
DGRW and QUAL are the market’s two largest quality ETFs. Here are some of their key differences:
DGRW applies quality and growth screens to the portfolio. This is particularly attractive given that we don’t think investors should be shunning growth stocks, but should instead pick securities that deliver growth and quality characteristics. Also in DGRW:
- The earnings growth ranking is 50% of the portfolio construction process and is derived from companies’ long-term earnings growth expectations.
- The quality ranking is 50% of the screening process, and is split evenly between three-year average ROA and three-year average ROE.
- DGRW removes companies with higher dividend yields. The logic here is that if companies are paying out more than they earn, companies may have to cut back their dividends in the future.
During the heightened volatility of Q4 2018, DGRW outperformed the larger quality ETFs as well as the SPDR S&P 500 ETF Trust (SPY) on the order of 100-200 bps (see chart below).
- DGRW’s top sector exposures are information technology (20%), industrials (19%) and consumer staples (12%).
QUAL tracks an index of U.S. large- and midcap stocks, selected and weighted by high ROE, stable earnings growth and low debt/equity.
- QUAL has been the clear leader so far, with $9 billion in assets in the quality space.
- QUAL tends to be more concentrated, with only approximately 120 stocks.
- The constituents in QUAL are quite different from DGRW, bringing different portfolio risk characteristics. QUAL’s top sector exposures are information technology (20%), health care (15%) and financials (14%).
At a glance, in the table below, you can see the different fundamental variables and sector weights different quality ETFs use. There’s no such thing as a one-size-fits-all quality portfolio, and understanding how these portfolio characteristics drive substantial return differences is key, especially given that investors are quick to rotate among ETFs within a segment based on a few basis-points differences.
Know what you own, and make sure what you consider to be quality aligns with the view different strategies employ to capture the quality factor.
You can reach John Davi at [email protected] or @AstoriaAdvisors. ETF holdings shown are for illustrative purposes only and are subject to change at any time. For full disclosure, please refer to our website: www.astoriaadvisors.com/disclaimer.