Market Overview

How To Get Quality In The Core

How To Get Quality In The Core

Many exchange-traded funds that are viewed as “core” holdings are cap-weighted. Core funds that emphasize individual investment factors usually focus on growth or value with quality often left out of the mix.

The FlexShares US Quality Large Cap Index Fund (NYSE: QLC) focuses on quality in a core holding package. QLC, which turns three years old later this year, follows the Northern Trust Quality Large Cap Index.

“The quality factor originally was designed as a tool to gain confidence in the financial strength of dividend-paying equities, but investors have steadily evolved how they use it in their portfolios,” said FlexShares. “Instead of looking at dividend-paying equities as a means to meet income needs, quality dividend payers can also be looked at as a means to grow assets through their core investments.”

What Happened

As FlexShares points out, the quality factor is often associated with dividends, but there's an important distinction to be made. Quality dividend payers usually aren't high yielders. QLC bears out that notion with a trailing 12-month dividend yield of just 1.43 percent.

That's below the comparable yield on the S&P 500 and less than half the yield on 10-year Treasuries. On the other hand, QLC's low dividend yield implies room for dividend growth among the fund's holdings and dividend growth, not yield, is a hallmark of many quality stocks.

Why It's Important

QLC itself isn't a dedicated dividend ETF, but all of its top 10 holdings, a group representing almost 22 percent of the fund's weight, pay dividends. Several members of that group, including Dow components Boeing Co. (NYSE: BA) and Johnson & Johnson (NYSE: JNJ), have lengthy dividend increase streaks.

Additionally, applying the quality factor to universe of U.S. large-caps is a sensible, potentially rewarding strategy.

“The extensive depth and history of financial data for these companies makes research quite robust, which in turn boosts convictions about how different factors perform in various market cycles,” said FlexShares. “And, liquidity and capacity issues, which may affect small caps or certain foreign markets, are generally not a concern.”

What's Next

Some of the bedrocks of QLC's strategy include management efficiency, cash flow and profitability.

“We believe applying these metrics is not only a great way to judge a company’s ability to maintain and grow its dividend, but also to gain insight into its overall financial health — and that holds true for dividend and non-dividend payers alike,” said FlexShares.

Additionally, nearly 48 percent of QLC's holdings are designated as value stocks, which positions the ETF for a potential value resurgence. Large-cap value outperformed large-cap growth in March and April.

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