Low-Cost Exposure to High-Quality Companies

Alex Bryan: Targeting quality businesses has long been a core tenet of many active managers' investment process. These are typically highly profitable businesses with durable competitive advantages and strong balance sheets. IShares MSCI USA Quality Factor (QUAL) offers low-cost exposure to these types of companies. It targets large- and mid-cap stocks with high returns in equity, low debt/equity ratios, and low earnings-growth volatility during the past five years.

Holdings are weighted according to both their market capitalization and the strength of these quality characteristics. This results in a growth-oriented portfolio that tilts toward wide-moat stocks. In fact, wide-moat stocks currently account for more than 64% of the portfolio. The types of stocks the fund holds have historically tended to hold up better than most during market downturns and generally exhibit lower-than-average volatility. The fund itself was only launched in July of 2013, so it does not have much life history, but its index was backfilled to 1975.

Now, it's prudent to discount back-tested performance, especially as the index start date followed a period of poor performance for quality stocks. That said, independent research from principles at AQR found that firms that have more-desirable characteristics such as strong profitability, attractive dividend payouts, growth, and lower risk tend to outperform their lower-quality counterparts across many different markets.

Now, this could be because investors may not fully appreciate the long-term sustainability of these quality firm's profits and undervalue them, even though they tend to trade at higher valuations than lower-quality stocks. But valuations do matter, and this fund does not take valuations into account, which may slightly detract from its appeal. However, its low 15-basis-point expense ratio should serve investors well in any market environment.