Hidden Quality in Dividend ETFs
Your dividend ETF might have another trick up its sleeve: efficient exposure to the quality and value premiums.
Interest in quality investing has heated up in recent years, triggering the release of new quality-oriented exchange-traded funds. Several respected academics have released papers that aim to quantify quality/profitability's role as a predictive metric. What are arguably the three most important reports have come in quick succession: "Quality Minus Junk" by Clifford Asness, Andrea Frazzini, and Lasse Pedersen; "The Other Side of Value: The Gross Profitability Premium" by Robert Novy-Marx; and "A Five-Factor Asset Pricing Model" by Eugene Fama and Kenneth French. Their findings are consistent--profitable (high-quality) firms outperform unprofitable firms over time. However, do investors need pricier ETFs that target quality? As it turns out, there's an even cheaper way to access the quality (and sometimes value) premiums: through a dividend ETF, the old stalwart.
Novy-Marx's research shows that profitable firms, as defined as those with high relative gross profits/assets, outperform unprofitable firms. He also found that this ratio is about as successful as book/market as a predictor of future returns. Investors often use metrics like net earnings and return on equity to quantify profitability, but Novy-Marx's research suggests that "purer" accounting measures better represent true profitability by not penalizing firms for engaging in research and development, advertising, or other activities that reduce net earnings today but boost them in the future.
Abby Woodham does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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