The Flock to Quality
Benjamin Lavine, CFA, CAIA
Note: an edited version of this article was published on ETF.com
If you’re an asset allocator concerned about the near-term market environment – slowing global economy, global trade conflicts, Hard Brexit – but want to remain fully invested and avoid timing the markets, while reducing the ‘stress’ in your portfolio, what do you do?
Flock to High Quality smart beta or tilt your equity exposure towards High Quality.
By now, you may have been inundated with recommendations to move your equity portfolio to the high ground of High Quality – a general consensus call among Wall Street sell-side strategists and institutional asset allocators, and a frequent refrain at the 2019 Inside ETF Conference in mid-February.
High Quality was also highlighted by Bloomberg’s Enter the ‘Twilight Zone’ as Stock Nightmares Meet Credit Dreams, which discusses the paradoxical preferences of asset allocators to go 1) defensive in equities (High Quality), and 2) aggressive in fixed income (‘High Yield’). This position works if we enter a Goldilocks scenario of low, but positive, real economic growth that keeps the U.S. Federal Reserve on hold from raising interest rates. Such an environment also means that growth is ‘scarce’, which is why one would want to gravitate towards companies that have demonstrable growth and profitability embedded in High Quality smart beta.
Quality also tends to work when corporate earnings are generally positive but generated during a period of greater uncertainty or headline risks.
On the other hand, one could take a cynical view that the shelf life of an investment idea expires right when it reaches the ETF investor. After all, the time to hold High Quality was in 2018 when it outperformed both the S&P 500 Index and most of the major investment styles (Figure 1), when adjusted for market risk (look at its upside and downside capture throughout the year relative to the other strategies). Like a bad habit, ETF theme promotion and marketing tend to focus on what worked last year (think currency-hedged ETF product promotions in 2016 following U.S. dollar strength the prior period).
However, a reasonable case can still be made for positioning in High Quality, if you have a realistic understanding of what exactly the investor is buying and under what circumstances High Quality tends to perform better.
Figure 1 – 2018: The Year of ‘Quality’ Outperformance
What Is High Quality?
There’s still some academic debate on whether High Quality should be construed as a risk factor: Why should investors be compensated with extra returns for investing in companies perceived to be safer and more profitable? Larry Swedroe provides a good summary of this debate in Getting to the Cause of Quality, where he references the Robert Novy-Marx 2012 Paper on the Gross Profitability Premium, the primary basis for why Dimensional Funds added Profitability to their investable factors (the others being market risk, size, value).
High Quality can be defined in many ways: stronger balance sheets, higher returns on capital, higher profitability (i.e. operating margins), more stable earnings, and/or better earnings quality (i.e. lower accruals). Basically, buying the companies you’d be proud to own.
Whether due to structural, behavioral, or rational risk-based reasons, there is evidence of excess returns associated with High Quality. But there is further debate as to whether the anomaly is driven more by the poor performance of Low Quality companies as opposed to the outperformance of High Quality companies. In other words, the excess return associated with High Quality may not be symmetrically distributed between high vs. low quality companies.
Why the Near-Term Shift to Own High Quality?
As seen from Figure 1, what you wanted to own in 2018 was ‘Low or Minimum Volatility’ but this was primarily due to the sharp sell-off in the fourth quarter (you could have also reduced your equity ratio down to 60% or 70% versus bonds, which is about the comparable level of risk offered by Low Vol). If you’re generally still concerned about further risk-off volatility like we experienced last quarter, you should simply own less equities.
Momentum also performed well in 2018, but it gave up a lot of performance during the fourth quarter sell-off, and it has now morphed into a more defensively-positioned portfolio (using iShares Edge MSCI USA Momentum Factor ETF (MTUM) as a proxy for momentum).
For asset allocators and investors concerned about the near-term market environment but who want to remain fully-invested, High Quality delivers the kind of risk attributes that provide nearly full market participation but with less stress. For purposes of this analysis, the iShares Edge MSCI USA Quality Factor ETF (QUAL) will be used as a proxy for High Quality investing.
And It’s difficult to argue against its attributes: High Quality is basically a better-looking version of the S&P 500 Index, and investors don’t need to pay up as much for better quality. Bloomberg data as of 2/20/2019 shows that:
- QUAL has a better balance sheet profile judging by credit rating exposure (Moody’s and Standard & Poor’s). On a portfolio-weighted basis, QUAL has 24%/23% exposure to Baa/BBB-rated & Below companies versus 33%/32% for the S&P 500.
- The near-term earnings picture for QUAL’s tracking benchmark, MSCI USA Quality Index, has not deteriorated as much as the S&P 500 Index (Figure 2).
- QUAL trades at 17.2x estimated 12-month earnings per share, based on Bloomberg consensus estimates, not much higher than the 16.2x for the S&P 500 even though QUAL has a higher projected return-on-equity (ROE) vs. the S&P 500.
- In addition, despite its strong relative performance in 2018 and consensus popularity, relative valuations do not look extended when compared to recent history. So High Quality doesn’t look ‘crowded’ from a sentiment or valuation standpoint.
- QUAL’s dividend yield is just under 2% or about the same as the S&P 500.
Figure 2 – The Earnings Picture for High Quality (Pink) Has Not Deteriorated as Much vs. the S&P 500 (White)
Source: Bloomberg using Bloomberg Consensus Earnings Estimates for the 1-Year Period Ending 2/20/2019
Figure 3 displays the Bloomberg risk model profile of QUAL vs. the S&P 500 Index (using SPDR® S&P 500 ETF (SPY) as a proxy). Some points worth highlighting:
- The market risk, or beta, is 0.98, so QUAL has similar market to that of the S&P 500. Investors are not giving up market risk in order to achieve higher quality.
- QUAL is projected to exhibit 2% tracking error (or +/- 2% return deviation from the S&P over the next year).
- Most of the projected tracking error can be sourced to positive exposure to Global Profitability (GL Profit), Bloomberg’s risk factor designed to capture the spread between High vs. Low Profitable companies. This shouldn’t be a surprise since Quality tends to be most directly associated with profitability.
- Keep in mind that QUAL is constructed to have similar sector weightings vs. a market-cap weighted portfolio, so sector risk is not a significant contributor to overall tracking error.
Figure 3 – QUAL’s Active Risk Profile vs. the S&P 500 Primarily Driven by Positive Exposure to Profitability
Source: Bloomberg Global Risk Model
Hence, QUAL essentially provides participation in High vs. Low Profitability, similar to the factor described in the 2012 Novy-Marx paper. Bloomberg’s Pure Profitability (“BPP”) factor used in its Global Risk Model is a useful proxy for capturing Profitability but should not be considered as investable, since it assumes full shorting with no transaction costs.
Perhaps somewhat intuitively, BPP tends to perform better during ‘stressful’ market periods while not capturing as much upside during more ‘blissful’ periods. Figure 4 displays the Rolling 1-Year Performance between the S&P 500 and BPP (remember BPP is long/short or market neutral, so its performance cannot be directly measured against a long-only index like the S&P).
Notice that the rolling returns tend to move in opposite directions from one other, particularly during sharp periods of sell-offs (2000, 2008, 2014-15, 4Q2018) and recoveries (2003, 2009, 20012-13, 2016). The monthly return for BPP during negative months for the S&P averaged 0.69% and -0.30% during positive months for the S&P. The average rolling 1-year correlation between the S&P and BPP is -0.46 with only positive correlations observed in 2014 and 2018.
Figure 4: Rolling 1-Year Performance of S&P 500 vs. BPP for the Period Ranging 12/31/2000 through 1/31/2019
Positioning for Market Stress Rather than Disorder
Investors positioning for higher quality are essentially betting on further market stress – but not necessarily disorder where all risky-assets are sold off in pursuit of immediate liquidity. With uncertainty around global trade disputes resulting in higher tariffs, BREXIT, upcoming European elections, and a slowing China economy, this positioning is not entirely unfounded.
But High Quality seems to indicate an increasingly consensus positioning even though it shows few signs of over-crowdedness. The risk with High Quality is that the market environment may prove to be less stressful, and/or the competitiveness of higher profitable companies may start to get eaten away through higher costs (whether due to rising wages or tariffs). Investors should be mindful of what they’re getting with High Quality, especially if the market stress they are anticipating does not come to pass.
As of the time of this writing, 3D Asset Management held positions in MTUM and don’t currently hold positions in QUAL and SPY. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as February 21, 2019 and are subject to change as influencing factors change.
By: Benjamin Lavine