As uncertainty mounts over the direction of the economy and financial markets, investors are flooding into exchange-traded funds focused on so-called quality stocks.
Quality stocks are those of companies with higher and more reliable profits, low debt and other measures of sustainable earnings. Presumably, these are the stocks that can withstand an economic downturn better than others, and advisers see exposure to quality as a way to reduce risk at a time when stock valuations are still high.
This year through September, some $4.6 billion has poured into ETFs focused on quality stocks, according to data from Bloomberg. That is more than the $3.5 billion that was invested in the strategy for all of last year and is the highest amount ever in any calendar year, says Todd Rosenbluth,who heads ETF and mutual-fund research at CFRA, a New York financial-data provider.
Corporate earnings are increasing a slower rate, and U.S. economic growth is slowing. Economies abroad are slowing, and a trade war with China as well as Britain’s still unresolved exit from the European Union are adding to uncertainty. All of these conditions “make the higher-quality ETF well-positioned to provide the stability investors who are still seeking upside will find of interest,” Mr. Rosenbluth says.
Focus on tech
But not all quality ETFs are built the same, experts say, and some have gotten expensive relative to the market.
One problem is that there is no set definition or criteria for “quality.” As Mr. Rosenbluth puts it, “quality is an example of a word that is open to interpretation. It is in the eye of the beholder.”
High return on equity—calculated by dividing net income by shareholders’ equity—is often included as one indicator of quality, as it is considered a measure of how effectively a company uses its assets to generate earnings growth. But funds also look at a combination of other data, including debt ratios, cash flows, net operating assets and even management attributes.
The biggest fund in the category, the $11.6 billion iShares Edge MSCI USA Quality Factor ETF (QUAL), has a fairly concentrated portfolio of 125 stocks and a 23.3% weighting in technology. Its biggest holdings are Apple Inc. (AAPL) and Johnson & Johnson (JNJ),at about 4% each, followed by Mastercard Inc. (MA), Facebook Inc. (FB) and Visa Inc. (V).
But unlike some other quality funds that focus only on large-capitalization stocks, QUAL looks at both large and mid cap stocks and ranks them by high return on equity, low debt-to-equity and stable earnings growth.
The fund is up about 22.1% this year through Oct. 1, according to fund researcher Morningstar Inc., and 11.2% over five years.
Invesco’s $1.5 billion S&P 500 Quality ETF (SPHQ) is even more concentrated, with 98 stocks, and nearly 44% of the portfolio invested in the top 10 holdings. It has a bigger weighting to technology, at almost 27%, with another 20.2% invested in health care. Top holdings are Apple and Microsoft Corp., at around 5% each.
The Invesco portfolio is built looking at three measures of quality: high return on equity, lower accruals (non cash-derived earnings) and low debt-to-book value (a measure of earnings stability). The fund uses a composite score of all three measures, plus a stock’s capitalization weighting, to rank equities, investing in those in the top quartile.
SPHQ has returned 20.6% this year through Oct. 1 and 11.2% over five years.
WisdomTree’s $2.8 billion US Quality Dividend Growth Fund (DGRW), meanwhile, layers a quality screen for high return on equity with a growth screen and ends up with a lower concentration in technology than some other funds, at 19%. An additional 14% of the portfolio is invested in consumer defensive stocks, which usually refers to companies that make food, beverages and household products. While Apple and Microsoft (MSFT) are its biggest holdings, the fund’s top five is rounded out by Verizon Communications (VZ), Exxon Mobil (XOM) and Procter & Gamble (PG), according to Morningstar.
The fund is up 18.1% this year and 11.4% over five years.
Other funds in the sector include J.P. Morgan’s relatively younger and smaller $104.5 million U.S. Quality Factor ETF (JQUA), which sorts large-cap stocks by profitability, earnings quality and solvency, and the $1.6 billion FlexShares Quality Dividend Index Fund (QDF), which focuses on companies that are paying dividends that are unlikely to be cut in the future.
Investors need to be cautious about valuation when investing in ETFs focused on quality, says John Daviof Astoria Portfolio Advisors, who started moving money into quality stocks during last year’s fourth-quarter market rout. QUAL trades at a price-to-earnings ratio of 19.8, while DGRW trades at 18.21. The S&P 500’s (.SPX) P/E is around 19.1.
Although companies with strong balance sheets and good fundamentals typically command a premium from investors, Mr. Davi says “quality has gotten expensive relative to the market,” in some cases.
Some investors may find the high concentration of tech stocks in some of these funds surprising, Mr. Rosenbluth says, because many people perceive the tech sector to be higher risk than others.
But Apple and Microsoft, along with financial stocks such as Mastercard and Visa, are “indeed blue-chip companies that happen to also be growth companies,” he says.
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