At its core, factor investing looks to utilize various attributes among equities to find an edge that will lead to outperformance of an index. And thanks to famed economists Fama & French, there is plenty of evidence that suggests factors are real and exploitable. Many asset managers successfully utilize factors in this manner. But some factors are more subjective than others, leading to active management wins.
Quality comes to mind.
Given the rising risks, high market valuations, and other economic issues, now may be the best time to consider quality stocks with an active approach. The factor offers plenty for portfolios in today’s age. Active ETFs have made applying the factor even easier.
Quality Is King
Factor investing targets securities with specific characteristics. And when it comes to factors, quality could be king of them all.
Quality is all about company fundamentals, business metrics, and health. All the stuff they teach you in finance 101, but most of us ignore when we’re buying meme stocks or the latest A.I. IPO. When it comes to the quality factor, we focus on aspects such as low levels of debt on the balance sheet, a high return on equity (ROE), positive profit growth trends, rising revenues, and profits earned through better margins and sales rather than accounting tricks. Moreover, dividends, buybacks, and shareholder-friendly management teams can also be considered.
The idea is to identify stocks of firms that represent strong, growing companies that are well-managed. With that in mind, quality stocks can fall under the “value,” “growth,” or “GARP” which is a combination of both styles headers.
It turns out that the quality factor is very important and offers portfolios a wide range of benefits.
For one thing, quality tends to outperform in the vast bulk of markets. Many other factors can lead to prolonged periods of underperformance. Asset manager WisdomTree has the data. Quality has managed to outperform 88% of the time. This chart from the asset manager highlights the consistency of rolling excess returns from the factor. While the chart is a bit muddled, the dark blue line is quality. 1
Source: WisdomTree
That consistency of returns is a significant win for long-term gains. With lower volatility, quality stocks have long been able to smash the broader market. The MSCI World Quality Index outperformed the MSCI World Index by a massive 1500% in the last 30 years.
Quality is a significant factor to focus on when building a portfolio. But it’s imperative today. That’s because rising risk and uncertainty complement its other attributes.
Volatility has only increased as economic woes, including a slowing economy, rising tariff threats, and stubborn inflation, have made equities a tough nut to crack. High valuations have also reduced long-term return expectations for stocks. All of this has increased downside potential. But quality has been a winner. Looking at the last 60 years, data shows that in 12 out of the 15 worst months for stocks, quality managed to cushion the drop and lowered the drawdown. Quality also offers the best upside/downside capture ratio of any other factor and straddles the line between cyclical and defensive-positioned factors.
Active Management Is Key
The thing is, some investing factors are easy to define. Take size, for example. We can easily slice up the equity universe into buckets based on market caps and make bets on smaller stocks. The same could be said for momentum. We can identify which stocks have forward price changes that exceed the market average. There’s some really complex data behind these factors.
However, when it comes to “quality,” the factor is a bit harder to nail down. It’s subjective. Fundamentals of any kind are open to interpretation and implementation.
Valuations are a prime example. Two different investors may have different takes on what a low price-to-earnings ratio means. What one considers cheap, another may consider expensive. Even looking at or creating a stock’s P/E in the first place can be up to interpretation. Do you use a 1-year earnings estimate or a 5-year average? Do we paint sectors with naturally higher debt levels, such as utilities and real estate investment trusts, with the same brushstroke as other low-debt sectors when considering debt-to-equity ratios? This is just the beginning.
Ultimately, the key is that quality can be challenging to index accurately. However, because many of the inputs that define the quality factor are subject to interpretation, it’s a fertile hunting ground for active managers. Active works best in sectors or areas that have numerous moving parts. Here, managers can apply their subjective expertise to build portfolios and determine what truly goes into those holdings.
There is evidence to suggest that active managers who focus on quality tend to outperform the market on a more consistent basis, rather than other active managers who concentrate on broad portfolios or specific styles, such as “growth.”
Active ETFs To Boost Quality
With active management potentially enhancing the returns of the quality factor even further, investors should consider incorporating it into their portfolios. The best part is that ETFs have further improved this scenario.
For one thing, the fee hurdle. WisdomTree’s research shows that quality beats the market by about 1.4% annually since 1990. That’s not a small amount, but higher fees from mutual funds still eat away at that return- potentially all of it. With ETFs, the fee hurdle is lower, allowing investors to reap a greater share of the gains.
Secondly, taxes come into play. Quality investors tend to be more “buy & hold.” This creates huge, long-term gains. However, ETFs’ ability to pass those gains through the creation mechanism provides meaningful tax savings for investors.
All in all, active ETFs are the best thing to happen to the quality factor since Benjamin Graham first started looking at the factor in 1934
Quality Focussed Active ETFs
These funds were selected based on their exposure to active management that focuses on the quality factor. They are sorted by their YTD total return, which ranges from 6.4% to 25.6%. They have expenses ranging from 0.13% to 0.56%. They have assets under management ranging from $200M to $6.2B. They are currently yielding between 0% and 4.2%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| NUGO | Nuveen Growth Opportunities ETF | $2.99B | 25.6% | 0% | 0.56% | ETF | Yes |
| FQAL | Fidelity Quality Factor ETF | $879M | 17.9% | 1.1% | 0.15% | ETF | Yes |
| QGRO | American Century U.S. Quality Growth ETF | $1.03B | 16.4% | 0.4% | 0.29% | ETF | Yes |
| VALQ | American Century U.S. Quality Value ETF | $207M | 14.7% | 1.7% | 0.29% | ETF | Yes |
| VFQY | Vanguard U.S. Quality Factor ETF | $307M | 11.1% | 1.6% | 0.13% | ETF | Yes |
| QINT | American Century Quality Diversified International ETF | $246M | 10.8% | 4.2% | 0.39% | ETF | Yes |
| QLTY | GMO U.S. Quality ETF | $1.85B | 8% | 0.78% | 0.5% | ETF | Yes |
| JQUA | JPMorgan U.S. Quality Factor ETF | $6.2B | 6.4% | 1.23% | 0.12% | ETF | Yes |
Ultimately, quality is a key factor for investors to focus on. Given its history of outperformance in many market scenarios, quality could be a big win today. Active ETFs could be the best way to utilize the factor in a portfolio.
Bottom Line
Active ETFs have further enhanced quality factor investing. With the factors of long-term outperformance, active ETFs provide lower costs and tax savings to help the factor achieve its full potential.
1 WisdomTree (March 2023). Four Key Characteristics that Make Quality Stocks a Great Long Term Core Holding
