The year of the global pandemic has so far rewarded risk takers. Quality-factor ETFs—known as a less risky blend of securities due to their focus on high quality companies with strong balance sheets—have largely lagged the broader U.S. stock market.
But that hasn’t kept investors away.
The iShares MSCI USA Quality Factor ETF (QUAL)—the biggest quality ETF, with $20.2 billion in assets—has trailed the SPDR S&P 500 ETF Trust (SPY) by almost 2 percentage points since the spring market low, while the First Trust Capital Strength ETF (FTCS) has lagged by almost 8 points. The disparity with the ‘Q’s’ currently sits in the double digits, as seen below:
Advisors and investors, however, have been slowly and steadily buying into quality, undeterred by the underwhelming performance relative to the market. Since the market low of March 23, quality ETFs have been gathering assets. Consider a sampling of funds:
Following The Money
Leading inflows is the First Trust Capital Strength ETF (FTCS), which has picked up some $117 million in net new money so far in October, bringing its March-23-to-date total to $2.07 billion in net creations—the most in this category this year.
The iShares MSCI USA Quality Factor ETF (QUAL), which is the biggest ETF in this segment and the one that dominates headlines, has taken in almost $500 million in that time frame.
Two things stand out here: First, demand for quality has continued steadily despite weaker performance relative to the market. As the table above shows, quality ETFs in general have all been net asset gainers.
That has happened because the attributes of a quality stock—and of these ETFs—are appealing to investors who are concerned about the impact a pandemic will have on companies longer term. With little forward guidance and surprising earnings results across the board, it’s difficult to know which companies will come out of this year with the biggest scars.
An accommodative and generous Federal Reserve has supported an equity rally despite massive economic disruption due to the virus, but many advisors and investors continue to bet on fundamentals, adding quality to their strategic core as a way to manage risk.
Quality And Then Some
The second interesting thing in these numbers is that QUAL, the largest and most traded quality ETF, has lagged FTCS’ creations significantly, almost 1-to-4.
QUAL has a lot going for it. It’s a broader portfolio, with 126 holdings, and a much, much cheaper wrapper, at only 0.15% in expense ratio—FTCS costs almost 4x that. QUAL also trades much more volume on a daily basis than FTCS at tighter spreads, on average. But it’s lagging FTCS in asset creations this year.
Why? It probably has something to do with how these two ETFs capture volatility more so than how they go about capturing quality.
Both funds base their security selection on balance sheet fundamentals, looking for strong return on equity, strong earnings growth, big cash-at-hand, etc. QUAL also weights securities based on these fundamentals, keeping the fund’s sector allocations in line with the broader market so there are not surprising sector tilts.
In the case of FTCS, the portfolio is equal weighted to minimize single stock risk, which in a year like 2020 when a handful of stocks have single-handedly driven this market higher, is something that has hindered the fund’s overall performance.
These are vastly different quality portfolios:
Different top holdings also impact overall returns:
But FTCS goes another step in its selection criteria by looking for quality stocks with lower volatility, giving the overall portfolio a lower beta than the broader universe—0.90. In other words, FTCS delivers a ride that’s about 10% less volatile than the broader market, whereas QUAL has a beta of 0.97, according to FactSet.
(You can find beta and other stats about a portfolio on the “Fit” tab in the fund page: https://www.etf.com/FTCS#fit)
“FTCS has less volatile exposure than other quality ETFs and the broader market, so it has allowed advisors to be a little more tactical in other parts of their portfolios,” First Trust’s ETF Strategist Ryan Issakainen said. “We’ve seen a lot of demand for thematic funds in cloud computing, cyber security and Internet, all of them higher beta. From a portfolio construction standpoint, if you’re allocating to these themes—as many are—and you don’t want to blow your risk budget, you want to use lower beta exposure to incorporate other plays such as quality.”
According to Issakainen, the "organic” demand for FTCS stems from its use in portfolios, as advisors adjust their risk levers tactically and strategically, looking to minimize risk. This is not an ETF that’s often used as a trading vehicle, he said.
The takeaway here is that while both funds deliver similarly on the quality factor—with QUAL slightly ahead—only FTCS has a deliberate focus on lower volatility quality stocks, as MSCI data shows:
We talk often about the importance of knowing what you own. The differences in these approaches, which are just two of the many options investors have when looking to access the quality factor, are a good reminder that, in single factor investing, funds often have additional intended or unintended factor exposures that can impact performance—and in this case, demand for the strategy itself.
Despite weaker relative performance in 2020, this year’s winning combo with investors has been quality with a side of low vol, please.
Contact Cinthia Murphy at [email protected]