Factor Series: Quality

During the first several weeks of 2022, the tech sector has experienced immense downward pressure. Many analysts are starting to use phrases such as “unprofitable tech” and “legacy tech” as a means of distinguishing between two groups within this sector. This distinction is being created as a quick way to reference those companies with solid balance sheets and financials (Microsoft, Oracle, Cisco) and those in their core growth phase with far less favorable financial metrics (Zoom, Roku, Teledoc).

Investors focusing on financials, valuations, and profitability is in stark contrast to the prevailing attitude over the past two years. Many unprofitable tech stocks saw their share prices driven up to unsustainable levels, based on little more than investor excitement and a positive momentum feedback loop. Vanguard Founder Jack Bogle often referenced stock prices “reverting to the mean” through various business cycles. That’s seemingly playing out before our eyes today.

Why does this matter, and what’s the link to our ETF factor series? In addition to factors such as momentum and value, there’s another often-overlooked factor: quality. With renewed interest in balance sheet health and other financial metrics, now is the perfect time to examine quality ETFs and the various exposures they provide investors.

Defining Quality

Like many other factors, quality is a generalized term used to represent companies with healthy fundamental ratios and high-quality balance sheets; however, the methods and ratios used to deem a company “quality” can be vastly different.

To level-set some commonly used fundamental ratios, here’s a quick refresher:

Return on Equity (ROE):

  • ROE = Net Income/Shareholder’s Equity
  • Purpose: Calculates the amount of profit for every $1 of shareholder’s equity
  • Over 10% is generally considered good; the higher, the better

Debt to Equity (D/E):

  • D/E = Total Liabilities/Total Shareholder Equity
  • Purpose: Indicates if Shareholder’s Equity can cover all debts
  • Ratio >1 implies there is more debt than equity
  • Ratio <1 implies there is more equity than debt

Price/Earnings to Growth (PEG Ratio):

  • PEG = (Stock Price/EPS)/EPS Growth %
  • Purpose: Adjusts the P/E ratio to include EPS growth (often called the “real value”)
  • The calculation is relative to the stock’s current share price, but typically the lower the ratio, the higher the earnings growth

The ratios for determining a company’s “quality” don’t stop there. Other commonly used ratios include: Return on Assets, Return on Invested Capital, Accrual Rates, Debt/Book Value of Equity, etc. No one analyst or firm often agrees on the best fundamental metrics to use.

Dissection and Differentiation

To assist with the visualization of the differences between quality ETFs, let’s compare and contrast the following funds:

  1. Invesco S&P 500 Quality ETF – SPHQ
  2. JPMorgan U.S. Quality Factor ETF – JQUA
  3. Fidelity Quality Factor – FQAL
  4. iShares MSCI USA Quality Factor ETF – QUAL

Descriptions and Objectives

Below are summarized descriptions based on the fund’s prospectus, fact sheet, and stated index methodologies.

Invesco – SPHQ

  • ETF Objective: Seeks to track the investment results (before fees and expenses) of the S&P 500 Quality Index.
  • Index: S&P 500 Quality Index
  • Eligible Investment Universe: S&P 500
  • Index Methodology: Quality composite scores are assigned to all S&P 500 stocks based on Return on Equity, Accrual Ratio, and Financial Leverage (as indicated by the company’s total debt/book value). The top 100 stocks with the best score will be included in the index. Stocks are weighted by a product of the quality score and float-adjusted market cap.

JPMorgan – JQUA

  • ETF Objective: Seeks investment results that closely correspond, before fees and expenses, to the performance of the JP Morgan US Quality Factor Index.
  • Index: JP Morgan US Quality Factor Index
  • Eligible Investment Universe: Russell 1000 – both large and mid-cap, including preferred stock
  • Index Methodology: Does not provide specific ratios or screening used, but summary prospectus does state: “proprietary selection process utilizes a quality factor to identify higher-quality companies as measured by profitability, quality of earnings, and solvency.” Approximately 250 market-cap-weighted companies are included at each index reconstitution.

Fidelity – FQAL

  • ETF Objective: Seeks to provide investment returns that correspond, before fees and expenses, generally to the performance of the Fidelity U.S. Quality Factor Index
  • Index: Fidelity U.S. Quality Factor Index
  • Eligible Investment Universe: Largest 1,000 US stocks based on market cap
  • Index Methodology: All stocks (ex-Banks) are given a composite quality score based on their Free Cash Flow Margin, Return on Invested Capital, and Free Cash Flow Stability. Bank stocks composite scores are calculated using Return on Equity and Debt to Assets. The stocks are also subjected to size-adjusted quality composite scores to remove size-related bias. (Read the details here: https://bit.ly/3tAMHLJ). Total holdings in the index will be roughly 130.

iShares– QUAL

  • ETF Objective: Seeks to track the investment results of an index composed of U.S. large- and mid-capitalization stocks with quality characteristics as identified through certain fundamental metrics.
  • Index: MSCI USA Sector Neutral Quality Index
  • Eligible Investment Universe: Constituents of the MSCI USA Index
  • Index Methodology: All stocks are given a quality composite score based on Return on Equity, low leverage, and low earnings variability. Stocks are then sector adjusted based on the quality scoring of each sector – typically adjusting each securities’ weighting by +/- 3%. The top 125 stocks with the best quality score are included in the index.

Equity Overlap

Anyone who has been around financial services long enough knows there are many different schools of thought around how to best capture an intended investment strategy. Look no further than the talking heads in the financial media who often disagree on the same subject, yet have access to all the same data.  

It’s no different when capturing companies exhibiting quality fundamental traits. Different schools of thought produce very different “quality” ETFs.

The chart below offers a holdings comparison as of 01/17/22. There are only 18 stocks held by all four funds, 41 by three, 98 by two, and 231 in a single fund – implying a total equity overlap rate of only 4.6% for all four funds! These funds start with nearly the same large to mid-cap universe, yet there is minimal overlap in underlying holdings.

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Source: ETF Action

Here’s how overlap looks from a fund vs. fund perspective:

  1. SPHQ and QUAL: 43 stocks
  2. SPHQ and JQUA: 56 stocks
  3. SPHQ and FQAL: 28 stocks
  4. QUAL and JQUA: 81 stocks
  5. QUAL and FQAL: 44 stocks
  6. JQUA and FQAL: 77 stocks

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Source: ETF Action

Performance

Similar to many other factor ETFs, the performance history can be somewhat limited due to the majority of launches coming within the last decade or so. To show an apples-to-apples comparison of the funds being discussed, below is a three-year total return chart starting in January 2019 – about a year after JQUA was launched.

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Source: ETF Action

Relative to the S&P 500, all funds other than SPHQ underperformed during this time period. SPHQ’s outperformance is rather substantial, coming in at +5%. SPHQ is the only fund in this sample that used an Accrual Ratio in its quality composite scoring.

Rebalancing

Index Rebalancing Tempo

  1. Invesco – SPHQ: Semi-annually, 3rd Friday of June and December
  2. JPMorgan – JQUA: Calendar quarter
  3. Fidelity – FQAL: Semi-annually, 3rd Friday of February and August
  4. iShares – QUAL: Semi-annually, June and December

Drawdown Comparison

2021 had two extended drawdown cycles, both shown below. SPHQ outperformed both times, declining less than the S&P 500, whereas QUAL underperformed both times, falling significantly more than the S&P 500.

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Source: ETF Action

Sector Exposure

As mentioned previously, since these ETFs all start with the same basic stock universe, one might expect the sector exposure to be reasonably close. For the most part, that’s the case – with the exception of SPHQ and the financials sector. Towards the end of 2021, yields slowly started to increase. Financials (banks specifically) tend to benefit from rising yields since they provide the potential for higher revenues from lending services, among other reasons. The only fund to rebalance during this time was SPHQ in late December. Although rebalancing is more luck than skill, occasionally, the timing is perfect for changing the exposure within a fund.

Sectors

Banks
Source: ETF Action

Conclusion

Like with other investment factors, the quality factor is subject to interpretation. Investors should carefully examine underlying methodologies to ensure they know exactly what they’re getting. Even though the methodologies for selecting quality stocks differ in each fund, there is no denying reversion to fundamental principles has merit at the moment. Even if you’re not interested in implementing a quality tilt to your investment portfolio, continue to watch these funds throughout 2022 to see what strategy works best in our ever-changing economic and investing environment!

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