Investing Basics: Consider Some Quality in Your ETF Portfolio

Exchange Traded Funds are designed to deliver the performance of an index, and customarily do so efficiently and cost-effectively. But what about when markets are turbulent? By Christian Leeming

That is when it may be worth seeking out a ‘Quality ETF’, composed of equities that have been shown to outperform the market over the long term.

These typically profitable, low debt companies, are embraced by what are known as Smart Beta ETFs which have the potential to boost the performance of a portfolio and may be better equipped to ride out market volatility.

Sometimes called ‘strategy’ ETFs these products blur the lines between truly passive trackers and actively managed funds by adopting an investment strategy that aims to outperform.

‘equities that have been shown to outperform the market over the long term’

Quality ETFs gained momentum in the US in 2014 where there are now 27 to choose from and they can be readily identified because ‘quality’ is usually found in the product name.

Quality ETFs seek to take advantage of the ‘Q’ factor – companies that make the best use of their capital to generate sustainable earnings and strong future cash flows; firms which invest capital more efficiently than their rivals tend to outperform in the long-run.

When creating a Quality ETF index the aim is to identify companies that are likely to be more efficient in terms of their use of capital; the following characteristics are often present in such companies and are known as ‘quality indicators’:

• Profitability
• Earnings quality
• Growth in earnings
• Stable dividend yields
• Low debt.

A company’s health, in terms of its suitability to be included in a quality index, is based upon one or more of these traits included in a formula devised to seek outperformance; the higher a company scores the greater the proportion of the ETF it makes up.

The data applied as quality indicators can usually be found in a company’s annual report and accounts; the following accounting metrics are all used when reporting a firm’s profitability:

• Return on assets
• Asset turnover
• Return on Equity
• Return on Invested Capital
• Gross profits / assets
• Profit margin

The quality of a company’s earnings quality can be divided into cash flow and accruals.

Strong cash flows often equate to future profitability as companies can use it to pay down debt and acquire new assets; conversely, high levels of accrual – stock held, property or equipment – historically correlate with lower future performance because valuations may be over-stated.

‘beat the market by 4% per year between 1963 and 2011’

‘Quality’ in the context of an ETF’s strategy is described as its ‘risk-factor’ as the performance of the product depends upon the successful selection of companies according to their quality indicators; risk factors associated with other strategy ETFs could be ‘growth and value’, ‘dividend’, ‘low volatility’ and ‘currency hedging’.

In comparison to other risk factors ‘quality’ has a very broad definition and therefore Quality ETFs can differ quite markedly in their approach.

Studies have shown that many different quality-based formulae have beaten the market over time; the strategy devised by quant Prof Robert Novy-Marx – the Gross Profitability Premium – beat the market by 4% per year between 1963 and 2011.
Different measures perform more strongly according to different economic circumstances; ‘return on equity’ for example has performed well during recession, whereas ‘low leverage’ enjoyed a golden period in the late 1990s but underperformed when the tech bubble burst at the turn of the Millennium.

Whatever their risk factor, Smart Beta ETFs introduce just that to a portfolio – increased risk.

Academic studies that have shown strategy ETFs to outperform based upon historical data often neglect to factor in the costs associated with such products and are not always faithful to an ETF’s methodology and structure.

Even if a historical analysis stacks up, that is no guarantee that any given risk factor will continue to outperform in the future, nor that any outperformance will be delivered smoothly; a risk factor may underperform for years before kicking in when economic circumstances change.

Risk factors do however deliver extra diversification to a portfolio as their performance diverges from the market and from each other; Quality ETFs exhibit low correlations with Value and Momentum ETFs which makes for a good combination in your portfolio.

The health of Quality firms enables them to withstand economic shocks and, as a group, they often benefit from a flight to quality when times are tough, but they quality equities don’t often standout during boom times.