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Get The Quality Fix With This ETF

August 23, 2016 8:49 am
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In addition to low volatility, the quality factor is the investment factor garnering the most headlines this year, as investors continuing displaying a preference for consistency and dependability over higher beta fare.

While different issuers of exchange-traded funds may have varying definitions for quality, hallmarks of this widely studied factor include high return on equity, consistent earnings growth, low debt, robust return on assets and, in many cases, steadily rising dividends.

Many ETFs offer exposure, in some form or fashion to the quality factor, but the iShares Edge MSCI USA Quality Factor ETF (iShares Trust (NYSE: QUAL)) is dedicated to it. The $2.67 QUAL follows the MSCI USA Sector Neutral Quality Index and is home to 125 “large- and mid-cap U.S. stocks exhibiting positive fundamentals (high return on equity, stable year-over-year earnings growth and low financial leverage),” according to iShares.

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While some factors go in and out of style, others prove durable over the long run and can offer investors some downside protection during rough markets. Historically, quality stocks do just that.

The Appeal Of Quality Stocks, ETFs

“The types of stocks the fund owns have tended to hold up a little better than average during market downturns. Their competitive advantages help protect profits and should make them slightly less sensitive to the business cycle than less advantaged firms. For instance, during the bear market from late 2007 to early 2009, the fund's index cumulatively lost 47.0 percent, while the MSCI USA Index lost 54.7 percent. However, it will likely underperform during strong market rallies,” said Morningstar in a note on QUAL.

Not The Same As Low Volatility

Quality and low volatility are different factors, but there many instances in which a stock can embody both factors. In fact, QUAL's three-year standard deviation of 10.8 percent is about 30 basis points below that of the S&P 500 over the same period. However, QUAL's three-year standard deviation is higher than the comparable metric on the iShares Edge MSCI Min Vol USA ETF (iShares Trust (NYSE: USMV)).

Technology, financial services and healthcare stocks combine for about 52 percent of QUAL's weight, which is only slight below the S&P 500 combined allocation to those sectors. QUAL's 23.5 percent combined weight to consumer discretionary and staples names is slightly above the S&P 500's exposure to those sectors.

QUAL's lineup includes some venerable, blue-chip names, which is a selling point and a disclaimer. A disclaimer because QUAL's constitution indicates that the ETF can deliver over the long run, this probably is not the appropriate destination for aggressive, short-term traders.

“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. So they are probably not attractive to aggressive investors, which could help 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,” added Morningstar.

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