The iShares MSCI USA Quality Factor ETF (BATS:QUAL) invests in large and mid-cap stocks screened for positive fundamentals. The idea behind this exchange-traded fund is that “quality” businesses should be able to outperform the broader market, which can be weighed down by weaker companies with poor financials. Indeed, QUAL has favorably returned 144% since the fund’s inception in 2013 and slightly ahead of 140% in the S&P 500 (IVV). That being said, we notice that QUAL has underperformed the S&P 500 more recently, including lagging this year, exposing some limitations of the strategy that excludes some high-growth market leaders. While we think QUAL is a solid ETF appropriate as a core holding for most investors, the strengths don’t necessarily warrant a rotation out of regular large-cap index funds.
According to the fund manager, the quality equity factor strategy is backed by academic research which finds that stable year-over-year earnings growth, high return on equity, and low financial leverage have historically driven a significant part of companies’ risk and return. The ETF passively tracks the MSCI USA Quality Factor Index, which identifies companies by fundamental variables with the included stocks weighted by market cap.
Taking a look at the current composition of the fund, QUAL is comprised of 125 equity holdings. The theme here is that the companies are recognized as having a strong balance sheet and generally segment leaders. Investors will notice familiar names such as Apple Inc. (AAPL), Facebook Inc. (FB), Coca-Cola Co. (KO), Nike Inc. (NKE), and Microsoft Corp. (MSFT) among the top positions in the fund.
(Source: Seeking Alpha Premium)
Compared to the S&P 500, there is a lot of overlap with many of the same stocks although the weightings vary. The top 5 stocks in QUAL total 19.2% of the fund, while the top 5 stocks in the S&P 500 represent about 22%. By this measure, QUAL is less “top-heavy” even while being a smaller and more concentrated portfolio.
In terms of holdings by sector, QUAL’s distribution with technology, financials, and healthcare as the most well-represented groups are similar to the broader market representative of a well-diversified portfolio. For reference, we are using the iShares Core S&P 500 ETF (IVV), which is part of the same fund family, and essentially, the iShares alternative to the more commonly traded SPDR S&P 500 Trust (SPY).
Our criticism here based on the above figures is that QUAL with a beta of 0.97 is too similar to the S&P 500 which limits the value of the fund as a portfolio diversifier. Going through all 125 holdings, we find that only 11 stocks totaling less than 4% of the fund are not constituents of the S&P 500.
It makes sense that the largest and most mature companies in the market will be considered “quality stocks”. What QUAL does essentially overweights some of the smaller constituents of the S&P 500 with the positive fundamental variables. As we explain below, this strategy has been detrimental to the fund’s performance this year, particularly as the largest mega-cap names have been the leading higher.
As mentioned, QUAL with a fund inception date in July of 2013 has outperformed the S&P 500 by about 2.5% over the period on a total return basis. On the other hand, taking a look at returns over more recent periods, we observe that QUAL has underperformed the broader market over a 5-year time frame and trailing IVV by 1.9% year to date in 2020.
(Source: data by YCharts/ table by author)
In terms of risk, the historic selloff earlier this year provided a good comparison during a market stress scenario. QUAL and IVV both fell by 34% as a max drawdown in late March. This example provides important evidence that the quality equity factor is not necessarily a defensive approach to investing since it declined by as much as the broader market.
With the market rally in recent months, one of the themes has been the strong outperformance of technology companies that don’t necessarily have stable earnings or currently high return on equity. Stocks like Amazon.com Inc. (AMZN), Netflix Inc. (NFLX), Tesla Inc. (TSLA) are up significantly this year and are not included in the QUAL ETF, explaining some of the underperformance.
It’s worth noting that the MSCI Quality Factor Index has historical data going back through 1994, which shows a longer-term outperformance with a 12% annualized return over the period compared to approximately 10.2% for the S&P 500. Our argument here is to consider the more recent market shift towards growth gaining importance compared to value traditionally more associated with the quality factor. QUAL is missing out on holding strong performers that simply don’t fit into the traditional “quality” factor in the traditional sense.
Separately, QUAL’s dividend yield of 1.46% is below the 1.8% yield offered by IVV which includes some high-yield names like AT&T (T) and Philip Morris International (PM) absent from the QUAL ETF. We also point out that QUAL has a slightly higher expense ratio of 0.15% compared to 0.3% for IVV.
Analysis and Forward-Looking Commentary
Overall, considering the mixed performance history, lower yield, and slightly higher expense ratio; QUAL just doesn’t appear superior enough to the S&P 500 for us to recommend it. Given the large overlap in holdings compared to the S&P 500, it’s unlikely investors will gain diversification benefits from adding the fund to an existing portfolio. While the quality equity factor is fine for what it is, it’s unclear the strategy will be able to outperform consistently going forward.
The market in many ways is forward-looking, and we think it’s important to have exposure to companies that are not considered “quality” stocks today but can be the leaders of tomorrow. Our criticism is that the fundamentals-based strategy here may be too backward-looking while ignoring the more recent trends in the market like high-growth tech for example. We expect QUAL to simply continue “tracking” the broader market but unlikely to significantly outperform to the upside or downside in a potential market correction.
In the context of the current environment where the market is at an all-time high, while many smaller companies are still attempting to recover from the economic disruptions of the pandemic, we also see value in beaten-down names and small-caps that will be able to emerge stronger going forward.
Investors should consider other equity-factor ETFs that can potentially offer exposure to less widely held companies and add to portfolio diversification. Sticking to the iShares fund family, we highlight the iShares MSCI USA Momentum Factor ETF (MTUM) as an outperformer over the past 5 years, up 131% compared to 90% for QUAL. MTUM strategy rotates into stocks exhibiting positive stock price performance which is also an academically recognized strategy known to deliver excess returns.
The iShares Core Dividend Growth ETF (DGRO) is another fund offered by iShares that invests in companies that have been consistently increasing investor payouts, making it interesting to income-focused investors. A contrarian pick might be the iShares MSCI USA Value Factor ETF (VLUE) which has lagged over the past decade but could benefit from a market rotation from growth to value if that scenario transpires. In terms of improving QUAL, we’d like to see it include small-cap stocks and or even foreign companies.
QUAL is a good example of a fundamentals-based strategy ETF that offers targeted exposure to financially strong companies with a positive long-term outlook. While the fund performs exactly as intended, the weakness is a lack of differentiation compared to a regular large-cap equity index fund, considering the significant overlap in holdings and similar risk-adjusted return profile. We take a neutral view of QUAL and recommend investors look elsewhere for a fund to boost returns within a diversified portfolio.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.