As exchange-traded funds have evolved over the years, we have seen greater interest in funds that screen for a specific factor. This may include historical volatility, size, momentum, or even “quality” characteristics. This last term in particular is one that is often used with great reverence, but may mean vastly different things to different investors.
Quality can stand for superior products or services, low debt ratios, profitability trends, sustainable dividends, or stable earnings growth. In practice, several of these screens may applied to a large universe of stocks in order to find companies showing superior balance sheet characteristics versus their peers.
One example of this model is employed through the iShares Edge MSCI USA Quality Factor ETF (QUAL). This smart-beta fund seeks out large and mid-cap stocks exhibiting solid underlying fundamentals. In the case of QUAL, this translates to high return on equity, stable year-over-year earnings growth and low financial leverage.
The end result is a basket of 125 companies with the highest scores in the three screening criteria. The largest holdings include well-known names such as Johnson & Johnson (JNJ), Pepsi Co (PEP), and Apple Inc (AAPL). Technology, financial, and health care companies currently make up the majority of the sector weightings within QUAL. Furthermore, this index is designed to revise and adapt over time as its constituents are regularly evaluated for their continuing merits.
While many smart beta ETFs are often known for their appreciably higher management fees, QUAL sports a reasonable expense ratio of 0.15%. This is likely a key factor in how the fund has been able to accumulate nearly $2.4 billion in assets since its inception less than three years ago.
It’s also worth noting that since the launch of this quality-focused strategy in 2013, it has added a measurable performance improvement over the broad-based SPDR S&P 500 ETF (SPY).
Another fund with a variant take on this theme is the PowerShares S&P 500 Quality Portfolio (SPHQ). This ETF is constructed by measuring return on equity, accruals ratio, and financial leverage of each of the stocks in the S&P 500 Index. The 100 companies with the highest quality scores are then included in the SPHQ portfolio.
This enhanced index is also weighted by a formula that multiplies the internal quality score by market capitalization. This provides an enhanced focused on quality markers rather than simply giving a larger slice of the pie to the biggest stocks in the group.
The unique methodology results in a markedly different portfolio and sector structure than QUAL. In fact, SPHQ has a high concentration of its holdings in industrial, consumer discretionary, and health care companies.
Lastly, the FlexShares Quality Dividend Index Fund (QDF) takes a distinctive approach by seeking out large and mid-cap stocks for expected dividend payments and fundamental balance sheet factors that include management expertise, profitability, and cash flow. The index is based on a multi-factor approach that includes quality as one of its core components.
QDF has 180 underlying holdings and a current SEC yield of 3.37%. The combination of a broader index alongside multiple screening criteria has this portfolio positioned heavily in financial, technology, and consumer discretionary stocks.
The Bottom Line
The ETFs mentioned above can be a potential benefit to investors who are seeking more focused exposure to companies exhibiting solid balance sheet fundamentals. Rather than combing through piles of financial data, these funds do the heavy lifting through their stock selection criteria and offer a multi-sector approach that may be broad enough to use as a core holding.
Nevertheless, it’s worth noting that publicly traded companies with quality characteristics aren’t always going to be the top performers in any given market cycle. There will be periods when these funds underperform a broad benchmark such as SPY due to their focused approach.
Disclosure: At the time this article was written, some clients of FMD Capital Management owned shares of QUAL.