Quality and value investment strategies often introduce ancillary sector bets, but it may be prudent to constrain them.
Factor strategies, such as value, low volatility, and quality, often end up with industry tilts that can be an unintended source of risk. In March 2017, Morningstar published a study that found that value and low volatility investment strategies exhibited consistent industry tilts that did not significantly contribute to their success. However, these tilts seemed to help momentum factor, where they were more dynamic. This suggests that investors could reduce active risk without materially sacrificing returns by constraining industry weightings among factor strategies with persistent industry tilts.
To investigate this further, I compared the performance of MSCI’s sector-neutral and unadjusted quality and value indexes across several markets. While quality was not covered in the previous study, it exhibits similar persistent sector tilts to value, so it would be reasonable to expect similar results. These indexes represent investable strategies, though much of their data is back-tested. The U.S.-focused sector-neutral quality and value indexes are available through iShares Edge MSCI USA Quality Factor ETF QUAL and iShares Edge MSCI USA Value Factor ETF VLUE, respectively.
In additional to constraining their sector weightings, these sector-neutral indexes select stocks based on their factor characteristics relative to their sector peers. Arguably, this approach could lead to better performance than only constraining the sector tilts. Valuations and quality characteristics, like profitability, tend to be more comparable within industries than across them, as firms in the same industry tend to have more-similar balance sheets and business models. Therefore, sector-relative factor characteristics may contain greater information about future expected returns than unadjusted factor data.
MSCI’s sector-neutral and unadjusted quality indexes facilitate a clean comparison that isolates the impact of sector adjustments. They both target stocks with high return on equity, low debt/capital, and low earnings growth variability over the past five years. The only difference between them is that one does not make any adjustments for sector membership, while the other measures each stock’s quality characteristics relative to its sector peers and sets its sector weightings equal to that of its parent index (which in the U.S. is the broad MSCI USA Index).
Exhibit 1 shows the differences in the performance statistics between MSCI’s sector-neutral and unadjusted quality indexes across four regions and three countries where both versions of the indexes were available. The data is from December 1998 through June 2017.
Surprisingly, this data suggests that the sector-neutral quality indexes have not offered a clear performance advantage over their unconstrained counterparts. None of the sector-neutral quality indexes generated higher returns than the corresponding unadjusted indexes. And five of the seven sector-neutral indexes exhibited slightly higher volatility than their unadjusted counterparts. This likely because sector adjustments cause the indexes to hold stocks with lower absolute quality characteristics than the unconstrained versions, which may be a little less defensive.
Five of the sector-neutral indexes exhibited lower tracking error against their respective market benchmarks than the unadjusted indexes. The sector-neutral versions should exhibit lower tracking error because their sector weightings mirror those of the market. This largely eliminates a source of active risk that the unadjusted indexes have. So, it is a little surprising that the Japan and U.K. sector-neutral indexes had slightly higher tracking error than their unadjusted counterparts, though this may be due to the limited size of these markets. Even though most of the sector-neutral indexes exhibited lower tracking error, only one (covering the U.S. market) exhibited a more favorable active risk/reward trade-off (measured by the information ratio) than the unadjusted version.