There are five primary investment factors for stocks: growth, low volatility, momentum, profitability/quality, small size and value. Of those five, quality is arguably the most overlooked and almost certainly the one with the most fluidity when it comes to defining its traits.
While there are varying definitions of what makes a stock a “quality stock,” there are some hallmarks investors can look for in an effort to identify quality securities. Those include strong return on equity (ROE) ratios, good corporate-credit ratings, low leverage ratios, capacity for and/or histories of buybacks and dividends and earnings variability.
Due to the variable definitions of quality and different applications of the factors, exchange-traded funds (ETFs) that emphasize quality stocks usually utilize varying methodologies. The Invesco S&P 500 Quality ETF (NYSEARCA:SPHQ) is one of the best ETFs that focuses on quality stocks, but SPHQ ETF has not always been dedicated to quality.
SPHQ ETF, which turned 13 years old last month, follows the S&P 500 Quality Index, a collection of the 100 S&P 500 stocks “that have the highest quality score, which is calculated based on three fundamental measures, return on equity, accruals ratio and financial leverage ratio,” according to Invesco.
The History of SPHQ ETF
SPHQ has not tracked the S&P 500 Quality Index for the entirety of its 13-plus years of existence.
“It recently cut its fee and, in June 2016, switched to a more transparent index, which targets firms with strong cash flows and balance sheets,” said Morningstar in a recent note. “It should hold up better than most of its peers during market downturns and offer attractive performance over the long-term.”
As for fees, SPHQ ETF currently charges 0.15% per year, or $15 on a $10,000 investment. While a slew of growth and value ETFs feature lower fees than SPHQ, the quality ETF’s expenses stack up favorably with its direct competitors as well as the broader universe of large-cap, smart-beta funds.
Over the past 36 months, SPHQ ETF trailed the S&P 500 by 540 basis points while being slightly less volatile than the benchmark U.S. equity gauge. During that same period, SPHQ outpaced the Russell 1000 Value Index by 350 basis points.
Measuring SPHQ’s performance against other single-factor strategies is instructive for multiple reasons. First, investors considering a single-factor ETF should and do measure that factor’s merits against other factors. Second, academic research and historical data confirm that stocks can simultaneously fit into several categories.
For example, in theory, it’s possible for a value stock to also be a low-volatility stock. Likewise, a growth stock can also be a quality stock.
SPHQ only holds large- and mid-cap stocks. Among its large-cap holdings, more than 53% are classified as either growth or value stocks.
Some single-factor ETFs are primarily weighted to just one or two sectors. For example, it is common for value funds to be primarily weighted towards energy and financial services stocks. Meanwhile, growth funds frequently have significant exposure to the consumer discretionary and technology sectors.
Since traits such as ROE and strong balance sheets are part of the quality factor, ETFs that focus on quality can have some sector-concentration risk. In the U.S., tech companies have some of the strongest balance sheets, best ROE ratios and some of the most prodigious generators of free cash, so it may not be surprising that over 39% of SPHQ is made up of that sector.
Conversely, sectors that are known to be home to highly leveraged companies make up very little of SPHQ ETF. The quality ETF has no exposure to utilities stocks while the real estate and materials sectors combine for just 2.21% of the fund’s roster.
“The types of quality stocks that the fund targets are unlikely to offer eye-popping returns, and they could lag the market for extended periods, particularly during strong market rallies,” said Morningstar. “So, they are probably not attractive to aggressive investors, which could cause them to become undervalued. These stocks should reward patient investors with a better risk/reward profile than the broader market over the long term.”
Todd Shriber does not own any of the aforementioned securities.