Ever been passed over for promotion by some smooth-talking stuffed shirt? Then take heart from the profitability factor [1]. 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 [2] 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 [3]
…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 [2] 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:
- Return On Equity (ROE) [4] – One of the most commonly used quality metrics.
- 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 [5] 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
[6]
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 [7] | 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 [8] analysed a suite of quality factors (not including gross profitability) and placed them in the following order of performance:
- Cash flow to assets
- Accruals
- ROE
- Low leverage
Cashflow was by far the best metric, with little separating the other three.
A second paper [9] – 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 [10] 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 [11]: 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) [12] and accruals [13].
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 [14], momentum [15] 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 [16] 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 [17] 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 [18]. That doesn’t overly bother me but it does bother [19] 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