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Diversified Exposure to Quality Stocks

This ETF offers a low-cost way to invest in profitable companies with durable competitive advantages.

Alex Bryan, 09/04/2015

Good companies don't always make good investments, but they may offer attractive returns relative to the market over the long term when they are trading at reasonable valuations, as they are now. Investors can get low-cost exposure to quality stocks through iShares MSCI USA Quality Factor QUAL (0.15% expense ratio). This fund tracks an index that targets large- and mid-cap U.S. stocks with high returns on equity, low debt/capital ratios, and low variability in earnings growth over the previous five years relative to their sector peers. It weights its holdings according to both the degree to which they exhibit these characteristics and their market capitalization. This skews the portfolio toward stocks with durable competitive advantages.

In order to mitigate unintended sector bets, the fund recently switched from the MSCI USA Quality Index to the MSCI USA Sector Neutral Quality Index, which anchors its sector weightings to the broad market-cap-weighted MSCI USA Index. This change probably won't have a big impact on long-term performance, but it likely will increase turnover and transaction costs, which could detract slightly from the fund's returns.

The types of stocks the fund owns have tended to hold up a little better than average during market downturns. Strong competitive advantages help protect profits and make these firms slightly less sensitive to the business cycle than less advantaged firms. However, they also can underperform for many years, particularly during strong market rallies. For instance, during the bear market from late 2007 to early 2009, the fund's index cumulatively lost 47.0%, while the MSCI USA Index lost 54.7%. However, it trailed this benchmark by about 0.8 percentage points annualized since the market bottomed in March 2009. This fund launched in July 2013, so it doesn't have a long performance record. While the back-tested performance of its index looks good, there is a risk that it may not work as well out of sample.

That said, there is a compelling case for investing in stocks with durable competitive advantages and strong profitability, including their tendency to outperform in tough economic environments. Recent academic research has revealed that stocks with strong profitability have historically outpaced their less profitable counterparts. 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. This fund does not impose a valuation discipline in its selection process, so it is important to pay attention to its valuation before investing.

Fundamental View
In a recently published study, "Quality Minus Junk," Cliff Asness and several other principals at AQR found that stocks with high and growing profitability, high payout rates, and low market volatility and fundamental risk historically outperformed their less advantaged counterparts. There is a chance that these researchers overfit the historical data in defining quality. However, their findings are consistent with research that shows that there has historically been a positive relationship between profitability and future stock returns. This effect is stronger after controlling for differences in valuations because more-profitable stocks tend to trade at higher valuations, which have historically been associated with lower returns.

There isn't an intuitive risk-based explanation for this effect. However, highly profitable stocks tend to perform similarly and there is a risk they could underperform the market for extended periods. The risk story has a little more merit after controlling for differences in valuations. The market may assign similar valuations to two stocks with different expected future profits if the more profitable stock is riskier in some way.

A more compelling explanation is that investors may not fully appreciate the long-term sustainability of highly profitable firms' earnings power and systematically undervalue them. To the extent that investors catch on and bid these stocks' valuations up, they may offer a smaller return advantage going forward.

This fund only directly captures profitability through its return on equity selection criterion. On this metric, and return on invested capital, the fund's holdings look significantly more profitable than the constituents of the broad Russell 1000 Index. Over the trailing 12 months through August 2015, the fund's holdings generated an average return on invested capital and ROE of 21.4% and 32.1%, respectively. The corresponding figures for the Russell 1000 Index were 12.4% and 19.4%, respectively.

Alex Bryan is an ETF analyst with Morningstar.

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