These 2 ‘Quality’ ETFs Have Unequal Exposure & Returns

It would be hard to argue against owning high-quality stocks.

How could an equity investor go wrong by holding top-quality names with strong fundamentals, companies that should be able to better navigate a market storm thanks to strong balance sheets, low levels of debt, and consistent, sustainable—and growing—profitability?

The theory and the academic research behind quality equity ETFs show they are designed to offer just that—relative outperformance relative to the broad market while mitigating downside risk in times of trouble. But that’s not always the case, for two key reasons.

Performance Disparity

First, quality is a factor. It’s a driver of returns, much like momentum, value and low volatility. That means quality, too, is susceptible to periods of underperformance. No single factor outperforms the market all of the time.

Secondly, as with everything else in the ETF market, the key to a passive quality ETF is its underlying index. And when it comes to quality equity indexes, there are no two alike. Methodologies vary significantly. That translates to performance disparity.

There are at least 85 equity ETFs on the market today that in one way or another look for quality companies. The segment is broad, with a varied mix of strategies. But consider two funds as a sample of the differences you could find in this space:

• iShares Edge MSCI USA Quality Factor ETF (QUAL), with $3.06 billion in assets and a 0.15% expense ratio.
• VanEck Vectors Morningstar Wide Moat ETF (MOAT), with $735 million in assets and a 0.49% expense ratio.

Here’s how they’ve performed this year relative to the SPDR S&P 500 ETF (SPY): 

QUAL, the largest ETF here, and a hugely popular one, raking in some $1.2 billion in fresh net assets so far in 2016, has been underperforming SPY by almost 2 percentage points.

Outperforming MOAT Sees Outflows

The fund is also under-delivering relative to competing MOAT by some 10 percentage points.

MOAT, the much smaller ETF that has actually seen net redemptions this year totaling $58 million thus far, has outperformed both QUAL and SPY by more than 9 percentage points each.

Both of these ETFs are considered funds that focus on top-quality companies, but their returns are vastly different, and here’s why:

QUAL picks stocks based on three fundamental metrics—return on equity, earnings variability and debt-to-equity—according to iShares, and then fundamentally weights them. The fund in the end owns 124 securities selected and weighted by fundamentals of quality, making it three times as large—broader and more diverse—than MOAT, which today has 44 holdings.

MOAT, meanwhile, is a value strategy at heart. It picks stocks with the lowest price to fair value ratio among firms with a sustainable competitive advantage, according to VanEck. The fund then equally weights these stocks, assigning them equal impact on portfolio returns. And this year, that value focus did well relative to the broad market.

Sector Differences

From a sector perspective, QUAL is the broader of the two, owning stocks in all 11 GICS sectors, while MOAT currently excludes exposure to four sectors—consumer staples, utilities, energy and telecommunications, which, combined, represent nearly 25% of QUAL’s sector exposure.

What’s interesting about this sector breakdown—if not puzzling—is that some of the sectors absent in MOAT are also some of the best-performing S&P 500 sectors year-to-date. But MOAT's sector allocations vary from time to time, the company said.

It’s worth noting in this performance comparison that MOAT's index underwent what the company calls "enhancements" this summer. Effectively, the fund started the year with only 20 names in the portfolio, and has since broadened its reach to now include over 40 securities. 

Does that mean MOAT is a better-quality ETF? Not at all. Nor does it mean it isn’t. It merely says MOAT is very different from QUAL.

If you go back and look at three-year total returns for these funds, MOAT has not only underperformed the broad market, but also underperformed QUAL, as the chart below shows. It’s worth noting that for the better part of the past three years, MOAT had only 20 stocks in its portfolio. The fund changed indexes this past summer. 

Charts courtesy of StockCharts.com

Todd Rosenbluth, head of ETF research for S&P Global Market Intelligence, sees benefits to both strategies. He says it comes down to investor choice.

“MOAT ranks favorably to us, primarily due to the valuation and risk assessments of the stocks inside the ETF,” said Rosenbluth, adding that the recent index change makes it difficult to really compare the two funds’ year-to-date performance. “QUAL is a stronger ETF to us, from a risk perspective, and has greater sector diversification.”

“Just like when the seas get choppy it makes sense to be in a higher-quality boat, investors are willing to pay up companies with stronger fundamentals,” Rosenbluth added. “Of course quality is an amorphous term, where it is defined differently by the index provider. As such, it is important for investors to look inside.”

Contact Cinthia Murphy at [email protected]