Quality Stock Factor ETFs
MyPlanIQ adopts asset allocation principle for portfolio management. Our candidate fund selection criteria are:
- For stocks, we advocate low cost index ETFs (or mutual funds)
- For fixed income/bonds, we advocate using a tactical portfolio that selects a fund from a list of high quality total return bond funds (our total return bond fund portfolios).
See March 6, 2017: Asset Classes for Retirement Investments for more detailed discussion.
Quality Factor Indexes
For stock investing, mostly capitalization weighted indexes are used. These indexes such as S&P 500 and Dow Jones Industrial Index normally select companies that have the highest market cap(italization) and weight them accordingly. For example, S&P 500 essentially select top 500 companies with the highest market caps, though the committee still can have option to decide to exclude/include certain companies based on some strict rules. These indexes are intuitive, natural, easy to rebalance and implicitly utilize the momentum factor — the better (higher) a market cap, the more it gets weighted.
With proliferation of ETFs in the past decade, variations of ETFs have been introduced. In fact, investors are very much overwhelmed with numerous types of ETFs, many of which are low quality.
Long term readers might have been familiar with our favorite stock investment philosophy: we believe stocks that have superior business model and consistent financial results are often the ones that can deliver superior long term returns. By superior business models we mean those that exhibit higher pricing power and their businesses are hard to be eroded, i.e. they possess so called moat that allows them to enjoy health profit for a long time. Interestingly, large businesses in certain sectors and industries often exhibit stronger moats. Sectors like consumer staples, utilities and healthcare were recently discussed in our newsletters. The companies in the three sectors often possess better and consistent business earnings than those in other sectors. Interested readers can refer to those newsletters.
These companies are usually viewed as (high) quality. Intuitively, they should have better than average long term returns. The following table shows some of the quality factor based ETFs:
|ETF||Expense||Total Asset||1Yr AR||3Yr AR||5Yr AR||5Yr Sharpe||10Yr AR|
|SPHQ (PowerShares S&P 500 High Quality ETF)||0.15%||1.5 B||10.2%||11.6%||11.3%||0.83||15.4%|
|QUAL (iShares Edge MSCI USA Quality Factor ETF)||0.15%||10.9 B||9.2%||12.8%||11.2%||0.8|
|MOAT (Market Vectors Mstar Wide Moat ETF)||0.49%||2.3 B||11.4%||14.9%||11.4%||0.77|
|VTI (Vanguard Total Stock Market ETF)||0.03%||119 B||8.4%||13.9%||10.7%||0.75||15.5%|
Among them, SPHQ changed its methodology a couple years ago and thus, its previous performance can’t accurately represent the quality factor. MOAT is based on Morningstar’s moat rankings whose methodology is not well defined and we believe it’s very much affected by Morningstar’s analysts, thus more or less subject to human opinions. Though this is not necessarily a bad thing so long it has a well defined process to follow, this ETF is again not a very good representative of the quality factor. Besides, it has the highest expense ratio, way more expensive than others.
The most representative quality ETF is QUAL that’s based on MSCI US Quality factor. We want to point out recently, Vanguard also introduced its quality stock ETF (VFQY) that’s base on the same MSCI index. Since VFQY is too new and only has $23 million asset, it’s excluded in the table.
Let’s look at QUAL in more details
iShares MSCI US Quality ETF (QUAL)
From the above table, we can see this ETF has a reasonable expense ratio (0.15%) and it has performed well, better than VTI in the past 5 years.
Based on MSCI, the index methodology is as follows:
The MSCI Quality Indexes aim to capture the quality factor with a simple and transparent methodology that ensures reasonably high trading liquidity and investment capacity of constituent companies, as well as moderate index turnover. A quality score for each security is calculated by combining Z scores of three winsorized fundamental variables—Return on Equity, Debt to Equity and Earnings Variability. MSCI then averages the Z scores of each of the three fundamental variables to calculate a composite quality Z score for each security, and then ranks all constituents of the parent index based on their quality scores.
The MSCI Quality Indexes are constructed with a fixed number of securities approach. A fixed number of securities with the highest positive quality scores is determined for each MSCI Quality Index with the goal of achieving high exposure to the quality factor while maintaining sufficient index market capitalization and number of securities coverage. All securities eligible for inclusion in the MSCI Quality Indexes are weighted by the product of their market cap weight in the parent index and their quality score. Issuer weights are capped at 5%.
The Quality indexes are rebalanced semi-annually, as of the close of the last business day of November and May.
High return on equity and low debt to equity imply that the business can operate efficiently (high return on asset with low leverage). Low earnings variability means earnings are consistent and less volatile. A high score in the three combination indicates the business is consistently making money without the burden of borrowing. The data, if looked long enough, might correlate well with wide moat the business has in its industry.
The weighting method is not purely market cap weighted so we might want to say this index is a smart beta index or at least a hybrid.
The latest top 10 holdings of QUAL:
These companies all possess moat according to Morningstar.
Intuitively buying and holding such companies for a long time should yield above average returns. From MSCI, the past index performance:
So for the past 25 years (since 1994), this index annually return extra 2% compared with a general market index. It’s certainly something that’s worth to consider.
To summarize, we believe quality stock index such as MSCI US quality index (QUAL or VFQY ETF) can be a very good value added or even a core fund to hold. However, we also want to point out that this index is still subject to a typical market gyration: as investors are more and more clamored for quality company stocks, their prices can be pushed too high. This eventually will lead to mean reversion that often undershoot a lot in a market downturn. Of course, if you are a long term (by our definition at least 15, preferably 20 years) investor, you can simply ignore the interim steep loss. On the other hand, if you cannot withstand a large interim loss, you’ll still need to manage your exposure to such an index fund accordingly or utilize a tactical approach to alleviate large loss.
Investors are now waiting for more news from quarterly earnings reports as well as for the Federal Reserve’s interest rate decision in the end of this month. For now, popular stock indexes like S&P 500 and Dow Jones Industries are all at record territories. However, again, we want to point out that small and mid cap company stocks are still not able to breach their previous highs. We again call for staying the course.
For more detailed asset trend scores, please refer to 360° Market Overview.
In terms of investments, even after the recent retreat, U.S. stock valuation is still at a historically high level and a bigger correction is still waiting to happen. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future.
We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.
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–Thanks to those who have already contributed — we appreciate it.
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