Most investment factors are easy to understand. Value stocks are those names perceived to be trading at discounts to the broader market. Growth stocks are those posting superior earnings and revenue increases, while the low volatility factor offers exposure to equities with favorable volatility traits.
When it comes the quality factor, however, there are varying definitions and traits used by investors to assess what constitutes quality.
“It’s likely the factor where opinions are most diverse regarding the definition,” according to Factor Research. “Broadly speaking there are qualitative and quantitative evaluations and these are often combined in a scoring model. Criteria like management quality or the soundness of strategy are intuitively appealing, but difficult to verify given a lack of data.”
While definitions for quality vary, some of the factor’s stickier attributes would include companies that are not highly leveraged — or at the very least if they carrying debt, they have strong credit ratings and interest coverage ratios, strong return on assets (ROA) and return on equity (ROE), modest earnings variability, and solid management teams. Penchants for rewarding investors via buybacks and dividends can also be part of the quality assessment.
Investors wanting to integrate quality into their portfolios are in luck because there plenty of dedicated quality ETFs on the market today. Here are some of the best of breed quality ETFs to consider.
iShares Edge MSCI USA Quality Factor ETF (QUAL)
Expense ratio: 0.15% per year, or $15 on a $10,000 investment.
Home to $10.55 billion in assets under management, the iShares Edge MSCI USA Quality Factor ETF (CBOE:QUAL) is the king of dedicated quality ETFs. QUAL, which turns six years old next month, tracks the MSCI USA Sector Neutral Quality Index and holds 125 stocks.
This ETF’s approach to quality is straight forward as it targets “stocks exhibiting positive fundamentals (high return on equity, stable year-over-year earnings growth and low financial leverage),” according to iShares.
Like other factor-based strategies, quality ETFs usually are not required to have overweight exposure to a particular sector or sectors. However, some groups often display more quality intensity than others. When it comes to QUAL, this quality ETF allocates almost half its combined weight to the technology, healthcare and financial services sectors.
Quality can also mean lower volatility as highlighted by QUAL’s three-year standard deviation of 10.94%, which is lower than the same metric on some other single-factor funds.
JPMorgan U.S. Quality Factor ETF (JQUA)
Expense ratio: 0.12%
The JPMorgan U.S. Quality Factor ETF (NYSEARCA:JQUA) is another dedicated quality ETF and an inexpensive one at that. With an annual fee of just 0.12%, JQUA is one of the cheapest single-factor funds that is not a value or growth strategy. JQUA uses “a rules-based approach that matches Russell 1000 sector weights and selects stocks based on quality and profitability characteristics,” according to JPMorgan Asset Management.
JQUA holds nearly 230 stocks, giving it a deeper bench than the aforementioned QUAL. Perhaps the biggest advantage of this quality ETF is its robust ROE. At the end of April, JQUA’s ROE was 28.36%, or nearly 800 basis points above that of the Russell 1000 Index, according to issuer data.
JQUA allocates about 55% of its combined weight to the technology, financial services and consumer discretionary sectors. Year-to-date, this quality ETF is higher by nearly 14%.
SPDR S&P Dividend ETF (SDY)
Expense ratio: 0.35%
As has been widely noted, dividends are integral to well-balanced portfolios and vital to investors’ long-term outcomes. Dividends are also one of the premier quality traits, particularly dependable dividend growth. Hence, the SPDR S&P Dividend ETF (NYSEARCA:SDY) merits a place in this discussion of quality ETFs.
SDY, one of the largest domestic dividend ETFs, tracks the S&P High Yield Dividend Aristocrats Index, which requires member firms to have increased payouts for at least 20 consecutive years. Although SDY’s components are weighted by yield, this is not a high-yield fund as highlighted by its trailing 12-month dividend yield of 2.37%.
The industrial, financial services and consumer staples sectors combine for almost half of SDY’s weight, giving it a different sector profile than the aforementioned quality ETFs. With the business cycle in its late innings, some market observers believe quality ETFs will benefit investors.
“Stretched valuations and slowing growth depict a late cycle environment, but this doesn’t mean that investors should abandon equities,” said State Street in a recent note. “Focusing on quality stocks with reasonable valuations may mitigate the episodic microbursts of volatility typical of a late-cycle market.”
WisdomTree U.S. SmallCap Quality Dividend Growth Fund (DGRS)
Expense ratio: 0.38%
Yes, the WisdomTree U.S. SmallCap Quality Dividend Growth Fund (NASDAQ:DGRS) has “quality” in its name, but this fund is a credible quality ETF for more valid reasons. Notably, DGRS’ weighting methodology emphasizes ROA and ROE.
Those are important traits with dividend stocks because strong ROA and ROE metrics imply companies not only have the ability to sustain current payouts, but raise those dividends in the future. Using ROA and ROE with small-cap stocks can prove efficacious because many smaller companies take on debt to fuel growth, punishing ROA and ROE along the way.
“We also know that typically companies that have the highest debt burdens are more acutely exposed to a deceleration in the economy,” according to WisdomTree.
Not surprisingly, DGRS outpaced the Russell 2000 Index by more than 450 basis points during the 2018 fourth-quarter market swoon. Although DGRS is a dividend growth strategy, its yield is more than double that of the Russell 2000.
Invesco S&P 500 Quality ETF (SPHQ)
Expense ratio: 0.15%
The Invesco S&P 500 Quality ETF (NYSEARCA:SPHQ) is one of the elder statesmen of the quality ETF group having debuted in late 2005. Age usually should not be a deciding factor when it comes to ETFs, but SPHQ’s long track record gives investors willing to do some homework an idea of how the fund has performed across multiple market cycles, good and bad.
SPHQ follow the S&P 500 Quality Index. That benchmark is home to 100 S&P 500 members “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.
For investors that want to focus on ROE, SPHQ is a quality ETF that makes a lot of sense because its ROE is a stellar 42.70%.
That says something about the technology sector because that group accounts for 41.71% of this quality ETF’s weight. Healthcare and consumer discretionary names combine for almost 21% of SPHQ’s roster.
Todd Shriber does not own any of the aforementioned securities.