Unless you happen to live in a cave, you will probably know that the big thing for investors and advisors to worry about now is INFLATION. Perhaps we should put that dread word in extra-large bold type and then print it out every day as a reminder that there is nothing guaranteed in investment except that a) excessive fees destroy returns and b) rampant inflation is a problem. Personally, I’m not sure we should be that worried about inflation over the medium term, but that debate is for another day. For now, millions of investors are scurrying back to their figurative drawing boards to rethink portfolio construction.
As they do so, my guess is that more than a few will start to utter the magic word – quality. Or more precisely, they will articulate in portfolio terms the need to look again at the quality stocks.
Perhaps the very best summary of this view came a few weeks back from an excellent note called ‘Inflation in the US economy’ by the equally excellent Brown Advisory. I’ll quote at length from their conclusion because I think it nicely sums up a consensus view among many smart investors:
We would posit that the equity of high-quality growing businesses that provide unique and valuable products and services can provide protection against inflation. The pricing power of a company is perhaps the most critical determinant of performance during periods of inflation, whether a company is considered growth or value. Warren Buffett has stated that pricing power is “the single most important decision in evaluating a business. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.” Companies with unique products or services, higher margins, and better management teams can pass along rising input costs and take share from their struggling competition.
Well put, but these sentiments pose something of a challenge for ETF investors. Although it’s true that assets under management in quality and quality income ETFs have almost doubled between 2018 and 2020, quality factor exposure still remains the Cinderella of investing; i.e., the object of great desire but poorly regarded and largely ignored.
According to one report, the total assets under management for quality ETFs remains under $30bn, which pales in comparison with other factor or smart beta strategies such as value, growth, or even low volatility. In fact, investors have allocated approximately $70bn to low-volatility ETFs, which I find rather peculiar. I understand why low vol is appetizing, but I think it rather confuses cause with effect. Sure, low vol is a desirable outcome, but would it not be better to understand the causes or more precisely the mechanisms that produce a less turbulent share price? My hunch is that such an exercise would bring you back to quality ideas, such as balance sheet strength, consistent earnings per share growth, consistent cashflow generation, and low leverage.
Yet by my count there are under 25 ETFs with ‘quality’ (and ‘quality income’) in the title, and many of them are quite small. If we’re honest the space is largely dominated by, you guessed it, BlackRock. The iShares MSCI USA Quality Factor ETF boasts $21bn in assets, while the iShares MSCI International Quality Factor ETF holds $3.5bn.
The mercy of quality?
Now, it’s quite possible that quality ETFs have become the Cinderella of factor investing because, to put it bluntly, they have not really provided superior risk-adjusted performance. That’s certainly the conclusion of ‘Oh, Quality, Where Art Thou?,’ an excellent research note by Nicholas Rabener, a quant analyst who runs the FactorResearch website.
To test out his early cynicism, he built equal-weighted indices for quality and quality income ETFs, which he then tested over the period 2005 to 2020 against the usual benchmarks. The result was significant underperformance and also a poor risk profile in terms of crisis drawdowns. Interestingly, his analysis also revealed that there was ‘was very little differentiation between quality and quality income, despite substantially different stock selection processes. Furthermore, a portfolio comprised of the 30% of stocks featuring the highest profitability would have outperformed all three indices, albeit before transaction costs.’
Rabener also picks up on another key issue – sector focus. I’ve long felt that too many factor-led strategies (value and growth, for instance, as well as quality) end up being undermined by sector concentration challenges – which, in turn, rather undermines the idea that these ETFs will provide sensible stock-level diversification. So, in quality, that means healthcare and consumer staples stocks dominate, while quality income ETFs have been overweight industrials and basic materials, and underweight technology stocks.
This sector concentration risk also runs in many different directions, of course, depending on which sector happens to be performing. Sector concentration can serve as a net positive, especially if you’d have been long tech stocks. All of which prompts the heretical notion that one could build a hybrid strategy that mixed quality alongside monopoly characteristics, while also ignoring some valuation metrics.
And in a sense, the one quality-like strategy that does do this is the ‘Wide Moat’ idea popularized by Morningstar and marketed by Van Eck, among others. Its flagship US fund has over $6bn in assets under management and has outperformed the S&P 500 benchmark over the one-, three- and five-year timeframes. Interestingly, it has a 16% exposure to information technology stocks, plus a tech-heavy healthcare selection of leading stocks with the top ten holdings, including Alphabet.
I’m also instinctively drawn towards the nuanced strategy pursued by the iShares ETF (the Edge MSCI USA Quality Factor ETF (QUAL)) which invests in quality stocks but only relative to their peers in the same sector. This provides greater diversification benefits.
Outside of the US, quality income, by contrast, has been much more popular with advisors and investors. In the UK, a derivation built around equity income has long dominated fund flows. But these strategies have also been consistently disappointing investors when measured against benchmarks such as the MSCI World. The headwind here has been the powerful momentum of non-dividend paying (tech) mega-cap growth stocks, skewing returns.
These quality dividend strategies now find themselves in a real pickle, as ably explained by SocGen’s star quant strategist Andrew Lapthorne, who observes that ‘there is a scarcity of dependable dividend yield. Where higher-dividend yields are on offer (i.e. Europe and Asia Pacific ex-Japan), dividend risk is the greatest and often highly reliant on financials.’ And a longer-term challenge is emerging – ESG. As Lapthorne notes: ‘ESG filters will reduce what an equity income investor can buy, but the real challenge comes from reducing carbon, as utilities traditionally pay big dividends.’
Yet if inflation does become a real challenge globally, quality dividend ETFs might prove a safe harbor, since as these stocks are less sensitive to higher bond yields, and tend to do better than fixed income. All that index developers need to do is make sure that resulting portfolios aren’t jam-packed full of legacy energy sector stocks.