Ever since economists Fama and French published the world’s first work on various investment factors, investors have long been enamored with trying to find an edge. Exploiting stock differences via attributes like value or size has become commonplace among portfolios. Perhaps none has worked over the long haul better than the so-called quality factor.
And it’s here that active management may have a real edge.
This is particularly important considering the current market, over-extended valuations, and growing economic risk. For investors, quality matters, and active management is the best way to get that exposure.
The Quality Factor in a Nutshell
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. Likewise, we can see which stocks have better-than-the-market forward price changes and which firms have better forward momentum. However, when it comes to “quality,” the factor is a bit harder to nail down. It takes a variety of inputs to create the factor.
When it comes to quality, it’s all about fundamentals as in actual business metrics and health. Typical quality inputs include items such as low levels of debt, on a balance sheet, high return on equity (ROE), positive profit growth trends, rising revenues, and profits earned via better margins and sales. Moreover, dividend, buyback, and shareholder-friendly management teams can be added to the equation.
In essence, you’re going back to Finance 101 and looking at the health of a business. As such, quality stocks can fall under the “value,” “growth” or “GARP” — which is a combination of both styles — headers.
So why go through the trouble? It turns out that quality is a factor that tends to outperform most of the time, unlike other factors that can have long periods of underperformance. According to T. Rowe Price, since 1997, the rolling five-year return of the MSCI ACWI Quality Index has managed to beat its broader market twin 85% of the time. By looking at actual returns, this chart underscores the outperformance of quality.
Source: T. Rowe Price
A Subjective Factor
Clearly, focusing on healthy companies is good for overall returns. The issue is that — unlike a factor such as size, which has hard data behind it — quality can be subjective. At their core, fundamentals of any kind are open to interpretation and implementation.
Take valuations. My perspective on a relatively low price-to-earnings ratio, e.g., a cheap stock, might be considered an expensive stock by another investor. Even looking at or creating a stock’s P/E can be up to interpretation. Do you use a 1-year earnings estimate or a 5-year average? Another example, are we allowed to throw out events when looking at revenues. Every company felt the crunch of the pandemic. Are we allowed to pull those events out of calculations when looking at revenues? Do we paint naturally higher debt sectors, such as utilities and real estate investment trusts, with the same brush stroke as other low debt sectors when considering debt-to-equity ratios?
As you can see, quality remains a factor where many inputs can be subjective — and that makes it hard to index.
Active Management Plays a Big Role
All of this subjectivity when digging into the metrics used to define quality stocks is a bit more hands-on than other styles of investing. And there lies a prime example of a place where active managers can get their hands dirty.
Here, managers can apply their subjective expertise in spades to build portfolios and determine what really goes into those holdings. There is evidence to suggest that active managers who focus on quality tend to be the ones who outperform the market on a more consistent basis rather than other active managers looking at broad portfolios or certain styles like “growth.”
This is particularly true in markets such as the one we are currently navigating. Overall, the markets have gotten pretty pricey as trends like AI have taken hold. Moreover, many investors have started to price in a plethora of Fed cuts well ahead of time. This is exactly the kind of market in which active managers focusing on quality can shine. Over-extension doesn’t make for good long-term returns, but those businesses that are doing well rise ahead.
ETFs have only enhanced the quality factor and made active management better. Lower costs via expense ratios and the ability to skirt capital gains taxes favor active management. Quality investors tend to be more “buy & hold,” generating very large long-term gains.
Quality 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 10.8% to 25.6%. They have expenses between 0.13% and 0.56%. They have assets under management between $200M and $3B. 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 |
In the end, quality remains a great factor for investors to exploit top-notch long-term returns. The issue is, when it comes to factors, quality is one of the most subjective around. It takes a human touch to actually dig in and exploit the fundamentals that build a quality stock. This makes it a prime hunting ground for active managers. ETFs have opened up the playing field for portfolios, and they have only enhanced the quality factor’s ability to outperform.
Bottom Line
With rising equity valuations and increased risk, quality is emerging as a top factor for portfolios. Focusing on fundamentals, investors have the ability to score long-term gains. The best part is that this is one area where active management can make a serious difference. Active ETFs make going the non-passive route better and at a lower cost.
1 T. Rowe Price (June 2024). The quality factor: Its impact, foundation, and evolution