Maximizing Returns: How Adding Quality Stocks Through ETFs Can Boost Your Portfolio

Some factors are pretty easy to define, such as size or momentum. We can easily slice and dice the universe of equities by market-cap and make big bets on smaller stocks. Likewise, we can see which stocks have better-than-market forward price changes to bet on momentum. ‘“Quality’ is a tad bit harder given that it takes a variety of inputs to define.

The idea behind quality is focusing on fundamentals. Company metrics such as low levels of debt on a balance sheet, high return on equity (ROE), positive profit growth trends, rising revenues, profits earned via better margins and sales, and dividend/buyback history are all hallmarks of quality stocks. At first blush, you might think quality stocks equal more familiar value stocks, but there are a few key differences. Value technically focuses on a low price (P/E, P/B or whatever) relative to the broader market. Quality stocks can exhibit these factors, but are required too. It’s all about business-driven metrics.

And it turns out adding those other ideas work well to create better returns.

According to asset manager AllianceBernstein, focusing on quality has been a great way to gain excess returns versus the broader market. Over the last decade, the MSCI World Index has managed to produce annual returns of 9.8%. Not too shabby. But by focusing on quality, the MSCI World Quality Index managed to produce a 12.4% annual return, or about 2.6 percentage points more per year. That’s a substantial difference. When looking at quality versus non-quality stocks in just the U.S., the results were similar, with quality outperforming by a wide margin.

Moreover, quality stocks have been less volatile than non-quality counterparts and have provided smaller drawdowns as well.

Given that quality has been a top long performer, investors should focus on the factor. And right now could be the best time to see quality shine.

For starters, the Fed’s pace of interest rates has raised recessionary concerns. The added banking crisis and the continued deterioration of valuations amid growth sectors haven’t helped either. To that end, stocks with real earning power, low debt, steady dividend payments, and other strong fundamentals are the type that have the ability to get through recessionary environments. Research supports this fact. According to a report by Investment Metrics, quality stocks beat the market by 21 basis points during recessions.

With volatility rising and recession risk growing, focusing on the factor is paramount.

The great news for investors is that the ETF boom has made adding a dose of quality stocks as easy as clicking ‘buy’ in your brokerage account.

The biggest remains the $21 billion iShares MSCI USA Quality Factor ETF (QUAL), which provides exposure to large- and mid-cap stocks that exhibit various quality metrics. Currently, the portfolio includes 124 different names and has done well over the long haul, producing a 10% annual return over the last five years, allfor dirt-cheap expenses of 0.15%. But it’s not the only fund available. The Invesco S&P 500 Quality ETF (SPHQ) offers a strictly large-cap focus, while the American Century Quality International ETF (QINT) can be used to bet internationally.

Given the subjective nature of ‘quality’, the factor is ripe for active management as well. Vanguard U.S. Quality Factor ETF’s (VFQY) managers make the final call on what stocks are included in the fund and cover the entire stock U.S. market (small-, mid-, and large-cap). While small at $185 million in assets, VFQY has done well to generate good returns. Another top choice could be the FCF International Quality ETF (TTAI), which uses quality factors as well as a quantitative model to generate its portfolio of top international stocks. For investors using mutual funds, the American Century Investments Focused Large Cap Value Fund Investor (ALVIX) blends quality and value factors to create a portfolio of cheap, fundamentally strong stocks.

To summarize, here is a list of some of the top-performing funds to get exposure to the quality factor.

 

Finally, there are plenty of individual stocks that make the cut. Our Dividend.com Rating system is essentially a ‘quality’ screener for dividend equities, with our Best Dividend Stocks Model Portfolio being a collection of top names. Investors can use the model or run our screen to find great individual stocks for their portfolios.

Factor investing is all about finding an edge and quality seems to be the best combination of fundamentals to gain that advantage. With recessionary risks growing, focusing on the factor through ETFs could be a great way to gain exposure and generate extra returns.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.