The Allure Of Quality In An ETF

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.

Some investors might not consider QDF to be pure-play quality since it explicitly screens for dividends.

Yet a third fund, the PowerShares S&P 500 High Quality ETF (SPQH | A-69), also includes a dividend screen and ends up with a completely different sector bias—one that heavily favors industrials and consumer stocks.

These sector biases help to explain some of the performance differences over the past year. QUAL leads the pack at 18.9 percent, QDF turned in 17.4 percent and SPHQ trails at 15.5 percent. Still, the appeal for these funds in my view isn’t in their recent performance in an upmarket but rather how they would fare as a defensive play in a downturn that has yet to materialize.

Still, what’s clear is that the returns of the like-minded funds don’t move in lock step. And how could they, given the huge differences in sector exposure seen above?

Among the three, I like QDF as a defensive play against an overbought market. It avoids major sector bets shown by the other two funds; has less market risk; and tends to capture a bit more market upside than downside over the past 12 months. (Please see the Fit tab of each report to see the relevant analytics.)

There’s little agreement here on which fund investors prefer: Assets are split roughly evenly for the three funds at about $500 million each. One thing is clear: A look under the hood of these three funds shows there’s little consensus of what “quality” means.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.