What do you get when you buy a Quality ETF?

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Quality ETFs focus on profitable, low debt companies that have historically weathered economic turbulence better than other equities.

What do you get when you buy a Quality ETF?
Certain equities have been shown by financial researchers to outperform the market over long time scales and across many countries. These high-performance sets of stocks are known as risk factors and have been popularised by Smart Beta ETFs that have the potential to boost your portfolio’s returns.

Quality ETFs seek to capture the Quality factor which tilts towards firms that make the best use of their capital to generate sustainable earnings and strong future cashflows.

Firms which can invest capital more efficiently than their rivals tend to outperform in the long-run.

The job of a Quality ETF’s index is to identify companies that are likely to be more efficient and it does this by following stocks which display certain characteristics.

Quality indicators

Commonly used indicators of Quality are profitability, earnings quality, growth in earnings, stable dividend yields and low debt.

Quality indexes will blend one or more of these traits into a formula which is used to gauge a company’s health.

The stronger a company scores, the more of its stock you will own in your ETF.

Quality traits are associated with accounting metrics that show up in a firm’s annual report. For example, a firm’s profitability may be measured by its:
  • Return on assets (ROA)
  • Asset turnover (ATO)
  • Return on Equity (ROE)
  • Return on Capital (ROIC)
  • Gross profits / assets
  • Profit margin (net income / sales)
Earnings quality can be divided into cash flow and accruals. Strong cashflows are associated with future profitability as companies can use it to pay down debt and acquire new assets.

Meanwhile, high levels of accruals have been historically correlated with lower future performance.

This is because accruals are non-cash balance sheet items like stock sitting in warehouses or property and equipment that may not prove to be worth as much as is currently claimed in the company’s accounts.

Quality can beat the market

What’s particularly notable about Quality in comparison to other risk factors is that it has a very broad definition. Therefore Quality ETFs can differ quite markedly in their approach.

Academic studies have shown that many different Quality formulas have beaten the market over time. The most famous version is Professor Novy-Marx’s Gross Profitability which beat the market by 4% per year between 1963 and 2011.
Different measures tend to perform more strongly according to different economic circumstances. For example, ROE held up very well during the 2000-2002 and 2008 recessions. Meanwhile low leverage enjoyed a golden period during the late 1990s but underperformed once when the tech bubble popped in 2000.

Improve your diversification with Smart Beta ETFs

One thing that any investor in Smart Beta ETFs needs to understand is that factor investing is risky. The amazing results achieved by the academics’ backtests involved shorting equities that did not display favoured traits as well as buying those that did.

ETFs, by contrast, don’t short and so are less likely to achieve the same level of outperformance. ETFs are also subject to costs and taxes that are disregarded by the academics.

There is also no guarantee that any risk factor will continue to perform as well in the future as it has historically. Even risk factors that have produced strong average returns over many decades can underperform the market for years before rebounding strongly.

That said, risk factors offer an extra degree of diversification as their performance diverges from the market and from each other. For example, Quality ETFs have exhibited low correlations with Value and Momentum ETFs which makes for a good combination in your portfolio.

What’s more, while Quality equities don’t often standout during boom times they have performed relatively well in periods of economic hardship. The health of Quality firms enables them to withstand shocks and, as a group, they often enjoy a ‘flight to quality’ when times are tough.

How to find a Quality ETF

To find Quality ETFs, go to the justETF screener and click on the Equity drop-down underneath All Asset Classes at the top of the left-hand column.
Then choose Fundamental / Quality from the Equity Strategy drop-down to see the choice available. The ETFs with the word ‘Quality’ in their name are the ones to investigate further.
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