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ETF Specialist

Get Defensive With This Quality ETF

This low-cost strategy targets stocks with attractive characteristics that should weather market downturns a little better than average.

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Investing in quality stocks sounds good, but it can mean different things to different people. Durable competitive advantages, strong profitability, low accruals, strong balance sheets, dividend growth, and consistent earnings are often among the attributes associated with quality. No matter how they are defined, quality stocks won't always keep pace with the market, but they can offer better downside protection.

One of the best quality investment strategies available is  iShares Edge MSCI USA Quality Factor ETF (QUAL), which carries a Morningstar Analyst Rating of Silver. While it probably won't beat the market in strong rallies, this low-cost strategy should hold up better than most of its peers during market downturns and offer better risk-adjusted performance over the long term.

The fund targets large- and mid-cap U.S. stocks with the best profitability (measured by return on equity), strongest balance sheets, and most-consistent earnings growth within each sector. These stocks often carry above-average valuations, and because the fund does not impose a valuation discipline, it tends to exhibit a growth tilt.

The strategy's sector-relative stock selection approach leads to cleaner comparisons, but it can cause the fund to own stocks with lower absolute quality characteristics than it otherwise would. To further mitigate unintended sector bets, the fund matches its sector weightings to the broad market-cap-weighted MSCI USA Index's. This adjustment can increase turnover, though turnover here is typically below the large-blend Morningtstar Category average. Within each sector, the fund weights its holdings according to both the strength of their quality characteristics and their market cap. This pulls the fund toward stocks with durable competitive advantages, such as  Gilead Sciences (GILD),  Johnson & Johnson (JNJ), and  3M (MMM).

The types of stocks the fund favors have tended to hold up a little better than average in market downturns. Their competitive advantages help protect profits and should make them slightly less sensitive to the business cycle than less-advantaged firms. For instance, during the bear market from late 2007 through early 2009, the fund's index cumulatively lost 47.0%, while the MSCI USA Index lost 54.7%.

In stronger market environments, the fund probably won't have a significant edge. And yet it generated solid performance from its inception in July 2013 through December 2017. During that time, it beat the MSCI USA Index by 61 basis points annually, landing in the category's top decile. This partially owed to more-favorable stock exposure in the industrials sector.

Fundamental View
Stocks with higher profitability and other measures of quality have historically offered higher returns than their less-profitable and lower-quality counterparts in most markets studied. It is tough to square quality stocks' strong historical performance with their seemingly attractive characteristics and below-average risk profile. 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. Because this fund does not take valuations into account, it is important to check the valuations of its holdings before buying.

Many investors are drawn to lower-quality stocks because they tend to offer greater upside potential than their higher-quality counterparts. This could help explain how these stocks become less attractively valued and priced to offer lower returns on average. The fund's holdings are unlikely to offer eye-popping returns, particularly during market rallies. But it should reward patient investors with a better risk/reward profile than the broader market over the long term.

Not surprisingly, the fund's holdings look much more profitable than the constituents of the broad MSCI USA Index, largely because of the inclusion of ROE in its selection criteria. Most of the portfolio is invested in stocks with sustainable competitive advantages that should allow these attractive profits to persist. The fund's inclusion of low financial leverage in its selection criteria penalizes companies that generate high return on equity through debt financing and reduces exposure to financial risk. It also indirectly tilts the portfolio toward more-profitable firms, which tend to be less dependent on debt.   

Earnings growth consistency helps paint a more complete picture of the strength of each business. The fund measures this dimension of quality with per-share earnings-growth variability over the past five years. This leads the fund to firms on stable growth trajectories, which tend to be less volatile than more erratic growth companies.

The fund's sector-relative focus facilitates closer comparisons, which should lead it to the highest quality names in each sector, helping it avoid persistent sector biases. This approach gives it greater exposure to the utilities and energy sectors than it would otherwise have. Sector weightings here are very similar to those of the Russell 1000 Index. While some of the fund's largest holdings have big weightings, the portfolio is well diversified and includes around 125 stocks.

Portfolio Construction
The fund employs full replication to track the MSCI USA Sector Neutral Quality Index, which selects stocks with high profitability, strong balance sheets, and stable earnings growth from the MSCI USA Index. The resulting portfolio favors firms with durable competitive advantages that should hold up a little better than average during market downturns, warranting a Positive Process Pillar rating.

The index screens for stocks with high ROE, low debt/equity, and low volatility of year-over-year per-share earnings growth during the past five years. MSCI assigns a sector-relative composite quality score to each stock in the MSCI USA Index based on these three metrics. It then selects the top-scoring stocks within each sector and sets its sector weightings equal to those of the MSCI USA Index on each rebalancing date. Stocks with higher sector-relative quality scores and market caps receive larger weightings in the index. However, the index adjusts these weightings to maintain sector neutrality. This adjustment may slightly reduce the portfolio's quality tilt and increase turnover. But the fund applies buffer rules to mitigate unnecessary turnover. MSCI reconstitutes the index twice a year in May and November.

Prior to September 2015, the fund tracked the MSCI USA Quality Index, which did not make any sector-relative adjustments. BlackRock switched indexes to mitigate sector tilts.

This fund's 0.15% expense ratio is a bargain. It isn't much higher than the lowest-cost market-cap-weighted index funds. BlackRock engages in securities lending, which generates ancillary income that partially offsets the fund's expenses. Full replication should keep tracking error low. During the trailing 12 months through December 2017, the fund lagged its benchmark by 23 basis points, slightly more than the amount of its expense ratio.

 PowerShares S&P 500 Quality ETF (SPHQ) (0.29% expense ratio) is one of the closest alternatives. It targets stocks from the S&P 500 with high absolute ROE, low financial leverage, and low growth in net operating assets. Similar to QUAL, SPHQ weights its holdings according to both their market caps and the strength of their quality characteristics. However, this fund does not make any sector-relative adjustments or constrain its sector tilts. Prior to July 2010, SPHQ did not track a quality-oriented index. 

 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 ETF (USMV) (0.15% expense ratio) should offer even better downside protection than QUAL. 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.



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Alex Bryan has a position in the following securities mentioned above: USMV. Find out about Morningstar’s editorial policies.