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How to invest in the profitability or quality factor

Ever been passed over for promotion by some smooth-talking stuffed shirt? Then take heart from the profitability factor. Also known as the quality factor, this is a real-world example of the triumph of the best over the rest.

The profitability/quality factor reveals that companies that make the best use of their capital outperform their less efficient brethren over the long-term.

In fact, the most profitable companies can bring home a return premium that has hitherto beaten the market by up to 4% a year.

The trick is to invest in the companies that are rippling with the signs of financial prowess most likely to predict profitability in the future.

Like a Moneyball chief scout or an international Top Trumps player, you need to know which stats matter most…

…or you could just pick an Exchange Traded Fund (ETF) with Quality in its name.

Quality over quantity

There are only three quality factor ETFs currently available to UK investors. Choosing one shouldn’t take long, right?

The snag is that financial engineers have more definitions of quality than the Eskimos have words for snow.

True, every kind of return premium can be formulated in different ways

But quality comes in so many flavours that you just know some must be watered down.

How do you choose the right version of quality? Is there a right version? Which has performed best historically? Does it even matter?

A trip down quality street

First of all, it’s important to understand that quality can be defined by a single measure, or by a cocktail of stats as drawn from a company’s annual report.

Here’s a snapshot of the yardsticks used by different industry practitioners:

  • Gross profits / assets – This is gross profitability as defined by Professor Novy-Marx and widely considered to be the champagne of quality factors.
  • ROE, debt to equity and earnings variability – Used by the MSCI Quality Indices.
  • Stability of earnings and dividends over the last 10 years – The S&P formula.
  • Gross profits / assets and gross profit margins plus free cash flow / assets – The preference of US fund house AQR.
  • Net income, operating cash flow, return on assets, stability of earnings, leverage, liquidity equity issuance, gross margins and asset turnover – The Piotroski F-Score financial health test.

Novy-Marx’s work caused a stir because his gross profitability metric trounced the market by 4% a year between 1963 and 2011. As a single quality metric it’s tough to beat and I’d want it or a close proxy in any quality fund I bought into.

However even Novy-Marx thinks that the best quality metric will be a blend of measures. For example, cash flow / assets is unpolluted by some of the accounting inconsistencies that can interfere with the gross profitability signal.

The question then is do the available ETFs offer us the finest quality cuts, or are they slipping in some horse meat?

(Or – worse – horse output!)

Quality ETFs

Each ETF has its own quality mix

The three ETFs I mentioned earlier all track developed world equities, using a blended metric to tilt their holdings towards the quality end of the spectrum.

The higher a stock scores on the fund’s quality scale, the greater its presence, subject to any applicable cap.

Note: These ETFs are so new that it’s not even worth considering their track record – they just haven’t been around long enough for their track record to be relevant.

ETF OCF (%)1 Ticker Quality metrics
iShares MSCI World Quality Factor 0.3 IWQU High ROE, low leverage, stable earnings growth
db X-trackers Equity Quality Factor ETF 0.25 XDEQ High Return On Investment Capital (ROIC), low accruals
Lyxor ETF SG Global Quality Income 0.45 SGQL High Piotroski F Score, strong balance sheet, high dividend yield

Source: ETF suppliers

Unfortunately I’m not in love with any of these ETFs.

iShares MSCI World Quality Factor ETF

Let’s start with the iShares offering.

Gross profitability appears to be the most successful of the quality metrics, but the iShares ETF uses ROE instead. Its weakness is that it focuses on net profit.

Gross profitability highlights companies that are investing in future revenues by devoting resources to R&D and advertising. But these beneficial activities subtract from a firm’s net profit and make it look less profitable in ROE terms.

The paper Global Return Premiums on Earnings Quality, Value and Size analysed a suite of quality factors (not including gross profitability) and placed them in the following order of performance:

  1. Cash flow to assets
  2. Accruals
  3. ROE
  4. Low leverage

Cashflow was by far the best metric, with little separating the other three.

A second paper – this time by Pimco – criticises the other two metrics used by the iShares ETF: low leverage and stability of earnings growth.

Here’s what the paper’s authors have to say:

There is little agreement that buying stocks of companies with low debt generates alpha. In fact, according to the evidence available in the academic studies of Bhandari (1988) and Fama and French (1992), low-leverage firms tend to underperform.

We are not aware of any empirical link between earnings volatility and expected returns. The only related papers, to our knowledge, are Haugen and Baker (1996) and Huang (2009). The former found no significant relationship between returns and volatility of earnings yields. Huang found the firms with stable cash flows tend to outperform.

Finally, the annual return of MSCI’s quality metrics (as tracked by the ETF) trailed in a lowly fourth place between 1985 and 2012, according to the paper Defining Quality by the asset manager Northern Trust.

It ranked the annual returns of various quality formulas as follows:

  • Piotroski F-Score: 8.4%
  • DFA’s metric2: 6.3%
  • ROE: 5.5%
  • MSCI 4.9%

Overall then, I’m unconvinced that the iShares ETF is using a particularly effective form of quality.

What’s more, iShares optimisation rules mean that it can hold stocks that are not in the index if it thinks the substitutes will give a similar performance.

The whole point of passive investing is to provide a set of rules that remove subjective judgements – rather than to provide enough get out clauses that the fund manager can effectively do what it likes.

db X-trackers Equity Quality Factor ETF

The Deutsche Bank ETF whips up its quality formula from Return On Invested Capital (ROIC) and accruals.

Accruals is okay as a quality factor but hardly a barnstormer according to the Global Premiums paper referenced above.

Moreover, accruals can be calculated in many different ways, which adds an extra level of complexity when you’re trying to work out what exactly you’re getting from the ETF.

ROIC does marginally better than ROE in the return stakes according to Pimco, but it’s still a net income metric that lacks the potential punch of gross profitability.

Once again, I’m left with the feeling that the quality on offer could be better.

And I’ve got even bigger problems with the index the ETF tracks – it’s owned by Deutsche Bank who also own this ETF.

Deutsche Bank can amend its index rules as it sees fit. That lack of independence makes me uncomfortable with a product that is meant to operate according to a strict set of rules. Rules don’t mean much if you can change them at a stroke.

Lyxor ETF SG Global Quality Income

Multi-factor products are probably the future – a single fund that enables you to combine the profitability, value, momentum and market factors all in one.

The Lyxor product feels like an early stab at this. It combines aspects of value (a high dividend yield) with quality (the Piotroski F-Score) and ends up with a defensive tilt that resembles a low volatility ETF.

As we saw earlier, the F-Score has proved pretty successful in the past at capturing the quality premium.

Big tick!

However Lyxor’s defensive recipe then concentrates the ETF in 25 to 75 companies (versus 298 in the iShares ETF) with a 32% allocation to utilities alone, according to its fact sheet.

That’s effectively a bet on a particular sector that we have no reason to believe will outperform. There is no evidence to suggest that any sector delivers excess returns over time, and investors are not rewarded for taking that risk.

So while the asset allocation of this ETF is significantly different from the other two, the lack of diversification makes me wary.

The index used is again the property of its parent company, Societe Generale, with the wheel clamp on independence that implies.

Finally, it’s a synthetic ETF. That doesn’t overly bother me but it does bother many others.

Quality streak

All three ETFs contain an element of quality but not the high-grade stuff I’m looking for.

If they combined gross profitability with cash flow then I’d feel much happier about signing up. As it stands I’d rather wait and see if anything better comes along.

It must be said that different definitions of any risk factor will outperform at different times. For all anyone knows, the quality metrics of these ETFs could hit an amazing streak in the years to come.

For example, ROE weathered the 2000-2002 and 2008 bear markets very well. Low leverage was a star in the late 1990s but fell from the sky after the 2000 tech bubble burst.

But all that is a matter for the gods. Right now, I’m content to watch these first-mover products build up their track record while I wait for other market players to improve upon them with the next generation.

Think of it as like buying a high-quality third-generation Apple wonder-gadget, rather than a first iteration device held together with innovative sellotape.

Take it steady,

The Accumulator

  1. Or TER. Learn more about the difference []
  2. Operating income before depreciation and amortisation minus interest expense scaled by book value – as practiced by passive investing fund house, Dimensional Fund Advisors. []

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{ 18 comments… add one }
  • 1 moneystepper December 2, 2014, 10:14 am

    Excellent summary Monevator – thank you.

    I was very interested to see “how” we could invest in the profitability factor in the UK, and this answers it well.

    Looks like neither of these ETFs are a good fit.

    Do you think that there are any other ways to “easily” invest in the profitability factor without using ETFs?

  • 2 Mr Zombie December 2, 2014, 12:03 pm

    Excellent reading.

    Accounting standards and their interpretation and evolution over the years must make this type of analysis really painful! Especially cross sector or country.

  • 3 rajkanwarbatra December 2, 2014, 1:41 pm

    It is really surprising that choice of ETFs focusing on quality is so low in UK.

    I would think that the professional investment managers should look at qualify of a company first and foremost.

    I guess the problem is short term focused nature of investment industry.

    Quality manifests itself in decades while the investment managers have to show result within an year.

  • 4 Tim December 2, 2014, 1:44 pm

    As ever, this made excellent reading.

    For the past few years I’ve been holding all SIPP funds in Vanguard’s LS 100% Eq Acc fund; primarily for ease and as I’m finding it hard to beat (alone) without adding more complexity. Being under 30, I’m happy with the 100% equity allocation.

    What I keep struggling with is if or when to switch holdings into utilising a (slightly?) more complex portfolio setup, if one exists. It feels like it’ll require immediately rebalancing (annual or otherwise), and with that comes the risk of chasing the next best passive fund.

    I suppose my question is this… is there a better single fund portfolio out there, or potentially on the horizon (for use over the long term)? Certainly, a Global Quality/Profitability-tilted Fund/ETF feels like it would be it, or ever a Fund of Q/P-tilted Index Funds.

  • 5 Grand December 2, 2014, 1:58 pm

    Great stuff – I was looking forward to this post from reading about the quality tilt last week. I hope as new products come to market you will revisit this post.


  • 6 Richard December 2, 2014, 5:11 pm

    I can’t help feeling that the Vanguard LS100% tracker will do you fine if you’re looking decades ahead. T/f to something less volatile as you get closer to retirement.

    I think there’s a human tendency to be greedy. Yes, I’d like 10% real returns. Or 20%. Or…

    But it’s much safer to aim for 4% real (or maybe 2.5% going forward) and do your financial planning on that basis. Any extra is a bonus.

    I find these articles endlessly fascinating, but I fundamentally don’t believe there’s a magic formula that allows me to beat the market. That’s why I’m moving to 100% passive in general global or UK trackers. (I still have some managed funds I need to get out of.)

    I don’t believe that we can know (beforehand) whether large cap, small cap, value, high yield, emerging markets, or any other selection method will give good results. And I don’t believe anyone else does either.

    But there is always the Siren call that holds out the (false?) promise of greater returns if only you invest This Way. Personally I’d rather not chase that will-o-the-wisp and so trade such worries for a good night’s sleep. Vanguard LS100%, with a 20+ year horizon should see you okay. Invest regularly, check once a year, and relax!



  • 7 DonF December 2, 2014, 6:23 pm

    Excellent article, thank you.

    One question though: isn’t the Lyxor ETF based in Luxemburg? I thought Luxemburg didn’t apply any witholding taxes to UK and European investors, same as Ireland?

  • 8 Gregory December 2, 2014, 6:30 pm

    Good article. I suggest You should write about iShares MSCI World Value Factor ETF and db X-trackers Equity Value Factor UCITS ETF too.

  • 9 mousecatcher007 December 2, 2014, 7:04 pm

    Quality Factor investing is a very interesting area, so many thanks to Mr Monevator for this article. The UK offerings are indeed uninspiring (and the DB X-Trackers ETF is hard to trade). But if you look across the pond there is plenty worth a look: Flexshares Quality Dividend Index (QDF) and International Quality Dividend Index (IQDF); Powershares S&P International Developed High Quality (IDHQ) and S&P 500 High Quality (SPHQ); Market Vectors MSCI International Quality (QXUS) and MSCI International Quality Dividend (QDXU). There are no doubt others too. As a bonus, dividends from US ETFs are paid gross in to a SIPP (providing your broker/platform is half competent and you are W-8BEN compliant).

  • 10 mousecatcher007 December 2, 2014, 7:30 pm

    I should add that Flexshares ETFs are offered by Northern Trust, the very same asset management company which published the ‘Defining Quality’ paper quoted approvingly above. Now just to look under the bonnet and check if they practise what they preach …

  • 11 kean December 3, 2014, 9:16 am

    Brilliant! I have been wanting to have a closer look at this whole area so learnt a lot from this piece. Thanks!

    Can’t remember exactly who but some one was interviewed on Sky News yesterday who said that their “committee” has raised a Red flag on two of the banks in the UK but apparently not allowed to name the institutions. He said on “deep dive” review the audited accounts were misleading.

    Not using this just as an anecdotal evidence but for some time now I have been wondering how would any one know if even audited accounts/Profit or Cashflow Statements are completely accurate.

    Assuming fund mgrs., largely rely on these like every other investor, how real would be their interpretation of “quality”. Add to that, agree that if a house owns the underpinning benchmark index & manages the fund then the fund would need very close scrutiny indeed.

    Ultimately it is all down to definition and interpretation of risk and quality. So then with the exception of charges, conceptually what is the difference between any of this new breed and “active” funds!

    I am too going to wait & see how this sub-group evolves.

  • 12 The Accumulator December 3, 2014, 11:02 pm

    @ Kean – I think that element of doubt is what makes diversification and compound quality metrics important. A fund that contains a wide range of companies is less likely to be knocked off course by a couple of bad apples and certain metrics will be harder to game than others.

    @ Don F – can you point me towards your domicile information? Lxyor is pretty opaque on this sort of thing.

    @ Tim – a range of multi-factor funds are appearing in the US, so I expect we’ll follow suit here over the next 5 years. I’d like to see a fund that incorporates profitability, value and momentum because those factors have reasonably low or even negative correlations so balance each other nicely.

    @ Richard – I whole heartedly agree with your sentiments, which is why I’d like to see a fund that diversifies between the various risk factors. So although we don’t know which will be successful in the years ahead, if we pick a portfolio of low-correlated factors then some will zig while others zag and we can pick up performance at a lower level of volatility.

    @ Moneystepper – I’m not aware of any other way to easily track quality. You could pick shares that tilt towards profitability but it wouldn’t be easy.

  • 13 The Accumulator December 3, 2014, 11:11 pm

    @ mousecatcher – do you invest in US ETFs from the UK? I recently read a piece about Canadian investors being potentially liable for US estate taxes upon their death if they hold US domiciled ETFs: http://www.taxtips.ca/personaltax/usestatetax.htm
    I wonder if this applies to UK citizens too? The exemption levels are pretty high but the US is getting increasingly aggressive on tax issues.

  • 14 Mathieu Lebrun December 4, 2014, 3:58 pm

    great article!

  • 15 mousecatcher007 December 5, 2014, 4:07 pm

    @ The Accumulator

    Yes, I do invest in US ETFs from the UK. I hadn’t considered the issue of US death duties, but at your suggestion some (very) cursory research suggests a UK resident very probably is so liable. That said, my US-listed assets are hardly substantial and I’m barely 40, so you’ll have to forgive me for not paying it much regard!

  • 16 DonF December 5, 2014, 10:54 pm

    @ The Accumulator – the clue is in the ISIN number. The ‘LU’ in LU1081771369 stands for Luxemburg, doesn’t it?

  • 17 The Accumulator December 7, 2014, 11:24 am

    @ DonF – great sleuthing! I’ve amended the piece.

    @ Mousecatcher – Ha Ha! I don’t blame you. Plenty of time to worry about that later. I did look into US domiciled ETFs myself last year but shied away when Youinvest put up their currency conversion charges. Who do you use as a broker? I’m only asking out of my own interest.

  • 18 Tyro December 7, 2014, 11:27 am

    @ Mousecatcher007:

    “As a bonus, dividends from US ETFs are paid gross in to a SIPP (providing your broker/platform is half competent and you are W-8BEN compliant).”

    I believe you are still subject to 15% withholding tax even with the W-8BEN and even though it’s a SIPP (or ISA). Monevator had a post on this at the back end of 2010.

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