Quality never goes out of style

Factors are identifiable, persistent drivers of risk and return. According to index provider MSCI, there are six main equity style factors: quality, size, value, momentum, dividend yield and volatility. Quality, in particular, has been receiving a lot of attention recently.

Quality investing encompasses several considerations, much to do with the financial characteristics of a company. Commonly accepted attributes of a ‘quality’ company include its profitability, earnings reliability, debt levels and balance sheet strength.

Identifying quality companies has been a focus of investors for a long time, Benjamin Graham wrote about it in Security Analysis way back in 1934. He followed up that with The Intelligent Investor in 1949, where he outlined, what has become the basis for, the quality factor. Graham said investors should demand from a company “a sufficiently strong financial position and the potential that its earnings will at least be maintained over the years.”

Such companies, he claimed, show resilience by falling less in a downturn and recovering to previous highs quicker than other companies.

These characteristics are identifiable in company reports. You can determine a company’s financial position by the strength of its balance sheet. Earnings are able to analysed, so too are company ratios. In the age of big data, several indices have been developed to capture the quality factor. They typically encompass some or all of the characteristics Graham sought. It is worth analysing just how good these indices are.

The best place to start is the beginning. The beginning of the Greek alphabet is alpha followed by beta. In funds management jargon, alpha represents the excess return a manager delivered above the market index. It used to be thought, only active managers could deliver alpha. Now factor investing such as quality can also deliver alpha.

Beta represents the returns of a manager that can be explained by the market. The market, is the market capitalisation indices which have become the standard measure for the market return, or market beta.

Smart beta is any index methodology that is different from market capitalisation. If you can build a smart beta index that captures the quality factor this would be considered a smart beta index. When building a smart beta index, you should start with beta.

Measuring risk and returns depends on beta measurement

Getting your beta right is a crucial first step in the process of offering an investment product that will harness those identifiable, persistent drivers of risk and return.

To measure the impact of any factor, including quality, your starting point must therefore be the benchmark index. For Australian investors investing internationally, that is the MSCI World ex-Australia Index. MSCI, the world’s largest index provider, have constructed a quality index by assigning a score for candidate companies included in the MSCI World Index.

For its quality index, MSCI scores companies on quality based on three fundamental characteristics:

1. High return on equity (ROE);
2. Stable earnings growth; and
3. Low debt-to-equity ratio.

There is a parallel between MSCI’s Quality characteristics and those that Benjamin Graham insisted investors should target in companies noted above. Nowhere did Graham suggest one characteristic was more important than the other. Subsequent research such as Smith (2010), Joyce and Mayer (2012), Novy-Marx (2012) Asness, Frazzini, and Pedersen (2013), and, Kozlov and Petajisto (2013) also did not favour one characteristic over another. Individually, MSCI found, each of these characteristics achieved a positive return against MSCI World Index. However, combining all three descriptors equally provided superior performance to the standalone descriptors, MSCI found.

Investors that start with the wrong benchmark may create a divergence and thus not achieve true exposure to the factor they are targeting. This discrepancy between the manager’s beta and the wrong starting point is known as benchmark misfit, according to a research paper from MSCI, Benchmark Misfit Risk:  Identifying the Risk Contribution Arising from Differences in Manager and Policy Benchmarks.

From an investor’s viewpoint, ‘benchmark misfit’ introduces two basic investment problems. First, it creates inconsistency in risk reporting. Remember factors are drivers of risk and return. Many risks are relative to the benchmark index, or beta. If you are harnessing a factor from a different starting point, its risk and return attributes may capture idiosyncrasies. Second, it introduces uncertainty in how and where the actual risk budget is being spent. Performance and risk is likely to be more idiosyncratic, and less attributable to the factor you are aiming to harness.

The VanEck Vectors MSCI World ex Australia Quality ETF (QUAL) starts at the right point. The ETF invests in a diversified portfolio of quality international companies listed on exchanges in developed markets around the world (ex-Australia).  The ETF tracks the performance of the MSCI World ex Australia Quality Index, which aims to capture the performance of quality stocks selected from the MSCI World ex Australia Index.

QUAL has outperformed over the long term, since its inception.

QUAL performance to 31 August 2020

_{*Inception date is 29 October 2014
Source: Morningstar Direct, VanEck. The chart above shows past performance of QUAL and of the MSCI World ex Australia Index. Results are calculated to the last trading day of the month and assume immediate reinvestment of dividends. QUAL results are net of management fees and other costs incurred in the fund, but before brokerage fees and bid/ask spreads incurred when investors buy/sell on the ASX. Returns for periods longer than one year are annualised. Past performance is not a reliable indicator of future performance.}

References: 

Asness, Clifford S., Andrea Frazzini, and Lasse H. Pedersen, 2013, “Quality minus junk.” Alternative Investment Analyst Review
Joyce, Chuck, and Kimball Mayer, 2012, “Profits for the Long Run: Affirming the Case for Quality.” GMO White Paper.
Koslov, Max and Antti Petajisto, 2013, “Global Return Premiums on Earnings Quality, Value, and Size.” Working Paper.
Lim, Eugene, Raphael Hung, Chin-Ping Chia, Subhajit Barman, Anand Muthukrishnan, 2015, “Flight to Quality: Understanding Factor Investing.” MSCI Research Insight
Miller, D., A. Rao and J. Menchero, 2013, “Benchmark Misfit Risk: Identifying the Risk Contribution Arising from Differences in Manager and Policy Benchmarks.” MSCI Research Insight
Novy-Marx, Robert, 2013, “The Quality Dimension of Value Investing.” Working Paper
Novy-Marx, Robert, 2012 (revised 2014), “Quality Investing.” Working Paper
Smith, Brian K, 2010, “An Investor’s Guide to Understanding the Impact of “Quality” on Portfolio Performance.” Atlanta Capital White Paper.