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Seeking Quality in the S&P 500

This fund favors highly profitable firms with durable competitive advantages.

Alex Bryan, 06/16/2017

PowerShares S&P 500 Quality ETF SPHQ did not always have a quality mandate. Prior to June 30, 2010, it tracked the Value Line Timeliness Select Index, which did not behave anything like a quality strategy. But because of poor performance, PowerShares moved the exchange-traded fund over to the S&P 500 High Quality Rankings Index on that date. That move wasn't great from a stewardship perspective (it would have been better for the firm to shutter the original fund), and it rendered much of the fund's performance irrelevant. It switched benchmarks again in March 2016 to the S&P 500 Quality Index, which applies a more transparent quantitative methodology.

This benchmark is well-crafted and, if the fund sticks with it, this strategy should hold up better than most of its peers during market downturns and offer attractive performance over a full market cycle. However, there is a cheaper alternative that better diversifies sector risk, and the fund has a limited history tracking its current index, which limits its Morningstar Analyst Rating to Bronze. 

The fund targets 100 stocks from the S&P 500 with the strongest quality characteristics. It measures quality based on high return on equity (a measure of profitability), low financial leverage, and low growth in net operating assets during the most recent year. Stocks that make the cut are weighted according to both the strength of their quality characteristics and their market capitalization. But the portfolio caps each stock's weighting at 5%. In contrast to its closest peer, iShares Edge MSCI USA Quality FactorQUAL, the fund does not make any sector-relative adjustments in its selection process.

The portfolio tilts toward highly profitable names with durable competitive advantages, such as Procter & Gamble PGPepsiCo PEP, and Stryker SYK, which help to protect profits and should make them slightly less sensitive to the business cycle than less-advantaged firms. They have tended to hold up a little better than average during market downturns, though that is not always the case. For instance, during the bear market from Oct. 8, 2007, through March 9, 2009, the fund's index lost slightly more than the S&P 500. The fund does not have a long record tracking its current benchmark. The back-tested performance of its index looks good overall, but as always, it is prudent to discount such hypothetical performance.

Fundamental View 
Firms that are more profitable and score well on other measures of quality have historically offered higher returns than their less-profitable and lower-quality counterparts. Cliff Asness and several other principals at AQR documented this effect in their paper, "Quality Minus Junk." They found that stocks with high profitability, high dividend payout rates, low market volatility, and low fundamental risk have historically outperformed their less-advantaged counterparts.

It is tough to square quality stocks' attractive historical performance with their seemingly attractive characteristics and below-average risk profile, which should command higher valuations and lower future returns. One possible explanation is that investors may not have fully appreciated the long-term sustainability of these firms' profits and undervalued them. However, that may not always be the case. Valuations matter, and quality stocks are not necessarily good investments at any price. Not surprisingly, the relationship between profitability and future stock returns is stronger after controlling for differences in valuations. However, this fund does not take valuations into account.

The types of quality stocks 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 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.

As a result of its return-on-equity selection criterion, the fund's holdings look significantly more profitable than the constituents of the S&P 500 on this metric and generate higher returns on invested capital. Most of the portfolio is invested in stocks with durable competitive advantages that should allow these attractive profits to persist. Nearly 60% of the portfolio is invested in stocks with wide Morningstar Research Services Economic Moat Ratings, our assessment that a firm enjoys a very durable competitive advantage.

Alex Bryan is an ETF analyst with Morningstar.

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