Quality ETFs Can Vary

If many U.S. equity mutual funds struggle to outperform the market-cap-weighted S&P 500 Index with stock selection, would investors be any better off using factor-oriented ETFs?

CFRA was a panelist at last week’s Inside Smart Beta & Active ETF conference, and this was a key discussion topic as the universe of low-cost single-factor ETFs continues to grow.

Andrew Ang, head of factor investing at BlackRock and one of the conference speakers, told the audience that investors no longer needed to pay up for active management masquerading as factor strategies.

Indeed, BlackRock offers a suite of single-factor ETFs, including the iShares Edge MSCI U.S.A. Quality Factor ETF (QUAL) and the iShares Edge MSCI U.S.A. Value Factor ETF (VLUE) which all charge a modest 0.15% expense ratio.

According to S&P Dow Jones Indices, just 35% of large cap active mutual funds outperformed the S&P 500 Index in 2018, largely consistent with the percentage in 2016 and 2017. From an asset-weighted perspective, these active funds lagged by 47 basis points in 2018 and 58 basis points on a three-year annualized basis. CFRA thinks the high expense ratios charged by active management, often 1.0% or higher, have dragged down relative investment returns.

And iShares is not alone in offering low-cost factor ETFs, as Fidelity, Invesco, J.P. Morgan and others charge fees considerably less than active mutual funds that select stocks using similar sounding approaches.

However, as CFRA highlighted at the conference, which firm’s factor ETF an investor chooses can impact a portfolio greatly, because what’s inside the portfolios of funds with the same factor in their names can be quite different.

QUAL vs SPHQ

Given the current environment, with moderate U.S. economic and earnings growth projections for the remainder of 2019, quality investing has been particularly popular. In particular, QUAL pulled in $2.8 billion of new money year to date.

The iShares ETF holds large- and midcap stocks that exhibit high return on equity, stable year-over-year earnings growth and low financial leverage according to its index provider. Indeed, the ETF’s top 10 holdings, which include Apple, Johnson & Johnson, PepsiCo and Walt Disney, are the type of blue chip stocks one would expect in an ETF with quality in the name.

(Use our stock finder tool  to find an ETF’s allocation to a certain stock.)

However, QUAL’s sector exposure is quite different than what the Invesco S&P 500 Quality (SPHQ) provides—notably, SPHQ charges the same 0.15% expense ratio. The Invesco ETF has 42% of its assets in information technology stocks, considerably higher than the 22% for QUAL. Meanwhile, SPHQ only holds 5% in financials, less than half the 13% that QUAL currently offers.

Quality ETFs Are Not All the Same

Source: Thomson Reuters Lipper as of June 3, 2019

We think SPHQ’s top positions in Microsoft, Visa and Cisco Systems, which meet the index’s return on equity, accruals and financial leverage ratio criteria, would also pass many investors’ eye test for high quality companies.

(Use our stock finder tool  to find an ETF’s allocation to a certain stock.)

Similar ETFs

The Fidelity Quality Factor ETF (FQAL) and the JPMorgan U.S. Quality Factor ETF (JQUA) are two other smaller and younger quality-oriented ETFs that CFRA rates. Yet a look inside reveals FQAL recently had 22% in information technology and 14% in financials, while JQUA had 25% and 8% of assets in these two respective sectors.

Despite the notable exposure differences, these ETFs collectively have performed relatively well in 2019. Year to date through June 3, SPHQ (up 12.2%) and QUAL (up 12.0%) have outperformed the 10.3% total return for the SPDR S&P 500 ETF Trust (SPY), while FQAL (up 9.8%) lagged; JQUA’s gain was in line with the cap-based index.

This thematic research was originally published on MarketScope Advisor www.cfraresearch.com/marketscope-advisor/