Hunting For The Right Quality ETF

The iShares Edge MSCI U.S.A. Quality Factor ETF (QUAL) has now gathered more than $4.5 billion in fresh net assets this year, making it the biggest quality ETF in the market today, and a very popular defensive-type factor ETF in 2019. But QUAL isn’t the only quality ETF available.

The fund’s asset-gathering success should come as no surprise in a year when so many investors have looked for ways to stay allocated to risk assets, but play defense at the same time amid fears of a recession given the slowdown in global economic growth.

Tracking an index of large and midcap U.S. stocks selected by quality metrics such as high return on equity, low debt-to-equity ratio and stable earnings growth, QUAL is today a $13 billion ETF, offering access to 127 securities for 0.15% in fees.

“Amid market volatility and an aging economic and business cycle, quality becomes more important for investors,” BlackRock’s Tony DeSpirito, director of investments for U.S. fundamental active equity, said in a recent blog. “We see a lot to like about quality, dividend-growing stocks in today’s late-cycle, low-interest-rate world.”

Investors Have Choices

QUAL’s size and liquidity—as well as a clear, easy-to-understand mandate to deliver access to the quality factor—make it a go-to choice for many investors.

But it’s not the only option. For example, the Invesco S&P 500 Quality ETF (SPHQ), which has $1.5 billion in total assets, picks stocks with strong fundamentals from the S&P 500 universe.

There’s also the O'Shares FTSE U.S. Quality Dividend ETF (OUSA), which blends the quality factor with low volatility and dividend yield in a strategy that has more than $540 million in total assets.

(You can see all ETFs offering access to quality in our Smart Beta ETF Channel)

What To Look For When Picking A Quality ETF

First, a quick look at performance. Year to date, these quality ETFs have kept pace—and some have outpaced—the returns of the S&P 500, as measured below by the SPDR S&P 500 ETF Trust (SPY):

Chart courtesy of StockCharts.com

A lot of times the choice to play defense with a factor such as quality isn’t driven by a desire to outperform as much as it is to have some form of downside protection in a portfolio, but strong returns are certainly a boon here.

Beyond performance, here’s what else you should know …

Many Sectors Offer Quality, Not Just Defensive

In his blog, DeSpirito noted that investing in quality doesn’t necessarily mean investing in defense sectors only. Quite the contrary.

“We believe investors can find quality in every sector, and would caution that the popular wisdom doesn’t always apply,” he said. “Sectors traditionally associated with quality, such as consumer staples and utilities, generally are not screening high on our quality metrics today.”

“What sectors are scoring well on our quality screens today? Health care and technology stand out,” DeSpirito added. The latter defies the idea that quality can’t be found in cyclical sectors.”

In QUAL, SPHQ and OUSA, Apple sits at the top as the largest holding in all three portfolios. The funds also share a strong tilt toward cyclical sectors such as technology and consumer discretionary. QUAL has technology at 30% of the portfolio:

SPHQ tilts dramatically into technology—much more so than QUAL—in search of quality names within the S&P 500, and sector tilts can have a meaningful impact on performance:

OUSA, too, leads with “riskier” sectors, but technology sits at No. 2:

Different ETFs Will Offer You Different Takes

Sector tilts are just one of the ways these ETF differ. If capturing the quality factor is what you seek, looking carefully under the hood is key, because there’s no single definition of what quality is. As an investor, you have to make sure the ETF you choose is accessing what you believe quality to be.

For example, consider this side-by-side comparison of QUAL, SPHQ and OUSA’s factor tilts (relative to the FTSE Russell 3000 universe), provided by Style Analytics:

If you zoom in on the different quality metrics alone (such as ROE, net profit margin and earnings growth stability, below), these portfolios take different views on what makes for quality, making QUAL (the yellow square) perhaps the purest quality ETF as it tilts strongly into all quality measures:

Also notable here is that OUSA (red diamond) offers the most muted quality tilt relative to QUAL and SPHQ, probably because OUSA is a multifactor strategy.

Instead, OUSA stands out for its tilt toward low vol and high yield relative to its peers:

Helpful Tips

On the surface, you could argue that for quality exposure, QUAL’s “purest” quality tilt is the best fit. But it could be that SPHQ’s tech-heavy focus or OUSA’s multifactor approach (among many other ETFs to choose from, of course) better meet your overall portfolio goals. Tom Idzal, managing director at Style Analytics, offered the following tips to choosing the right fit for you: 

• Understand how the ETF defines quality.

“Much like beauty, quality can be ‘in the eye of the beholder,’” Idzal said. “Investors need to make sure their own views on what is considered a quality company is reflected in the ETF they choose.”

• Understand what else you’re getting along with the quality bias. 

“As we've seen in just these three examples, there can be other exposures or sector biases that will be important to understand,” he said. “Knowing what you own, beyond the category label or the name of the ETF, is very important.”

Contact Cinthia Murphy at [email protected]