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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.

The financial leverage selection criterion indirectly skews the portfolio toward profitable companies, which are generally less dependent on debt. This metric also penalizes companies that generate high ROEs through debt financing. Targeting stocks with low net asset growth during the past year (which the index labels as an accruals ratio) tilts the portfolio toward firms with conservative capital expenditures and higher free cash flow. That said, it would be better if the fund's index applied a longer measurement window for this metric to smooth out year-to-year fluctuations.

Because the fund's holdings are generally more profitable than the constituents of the S&P 500, they tend to trade at higher multiples of book value. But the portfolio still falls squarely in large-blend territory. It has greater exposure to industrial, basic-materials, consumer cyclical, and consumer defensive stocks than the S&P 500 and less exposure to the financials, energy, and healthcare sectors.

Portfolio Construction
The fund employs full replication to track the S&P 500 Quality Index, which accurately represents the quality investment style. While this index is well-crafted, the fund's history of index changes limits its Process rating to Neutral. 

To construct the fund's benchmark, S&P assigns a composite quality score to each stock in the S&P 500 based on its return on equity, financial leverage (total debt/book value of equity), and net operating asset growth during the past year divided by average net operating assets. S&P calls the last metric an accruals ratio, and a lower value is associated with higher quality. It ranks the members of the S&P 500 on the composite quality score and selects the top 100 for inclusion in the quality index. Qualifying stocks are weighted according to both their market capitalization and the strength of their quality characteristics, subject to a cap of 5%, or 20 times their market-cap weighting. The fund's index applies a buffer rule to mitigate unnecessary turnover, which should help reduce transaction costs. It reconstitutes semiannually in June and December.

PowerShares charges a 0.29% expense ratio for this fund, which is competitive with other strategy index funds and low relative to its active large-blend peers. Therefore, it earns a Positive Price rating. However, QUAL offers similar exposure for a lower 0.15% expense ratio. Over the trailing 12 months through May 2017, the fund lagged its benchmark by 36 basis points, slightly more than the amount of its expense ratio.

The closest alternative is QUAL, but in contrast to SPHQ, it targets stocks with strong quality characteristics relative to their sector peers. QUAL then matches its sector weightings to those of the broad, market-cap-weighted MSCI USA Index to help investors avoid unintended sector bets. This sector-relative approach improves comparability but can also cause the fund to own some names with lower absolute quality characteristics than it otherwise would. Similar to SPHQ, it weights its holdings according to both the strength of their quality characteristics and their market capitalization.

Vanguard Dividend Appreciation ETF VIG (0.08% expense ratio) offers a similar quality tilt. It targets stocks that have increased their dividends in each of the past 10 years. Stocks that pass this hurdle tend to enjoy durable competitive advantages and high profitability.

Schwab U.S. Dividend Equity ETF SCHD (0.07% expense ratio) may be a more attractive quality option for value-oriented investors. It targets stocks with high ROE, high cash flow/debt, high dividend yields, and strong dividend growth during the past five years. This tilts the portfolio toward value and wide-moat stocks.

A low-volatility fund like iShares Edge MSCI Minimum Volatility USA USMV (0.15% expense ratio) is also worth considering. It uses an optimizer to construct the least-volatile portfolio with stocks from the MSCI USA Index under a set of constraints to improve diversification. Like most low-volatility funds, its holdings tend to enjoy relatively stable cash flows and hold up better than average during market downturns.


Alex Bryan is an ETF analyst with Morningstar.

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