This Quality ETF Has Gotten Better

Strong balance sheets, profits, and disciplined growth can make a difference in rocky market environments. Invesco S&P 500 Quality ETF SPHQ is a great option for exposure to these stocks, and it has gotten better over time. It recently cut its fee and, in June 2016, switched to a more transparent index, which targets firms with strong cash flows and balance sheets. It should hold up better than most of its peers during market downturns and offer attractive performance over the long term. This strategy warrants an upgrade to a Morningstar Analyst Rating of Silver from Bronze.

The fund targets firms with strong profitability and balance sheets, which are important dimensions of quality. It targets 100 stocks from the S&P 500 with high return on equity, low growth in net operating assets during the most recent year (which is a proxy for capital expenditures), and low financial leverage. Firms with high return on equity and low growth in net operating assets tend to have high free cash flows, which they can use to fund dividend payments and share repurchases or pay down debt. Stocks that make the cut are weighted according to both the strength of their quality characteristics and their market capitalization, subject to a 5% cap.

Highly profitable firms with durable competitive advantages, such as Procter & Gamble PG, Visa V, and Starbucks SBUX, anchor the portfolio. These firms have tended to be slightly less sensitive to the business cycle than average and hold up a little better during market downturns. For instance, during the bear market from Oct. 8, 2007, through March 9, 2009, the fund's index cumulatively lost 46.9%, slightly less than the S&P 500’s 55.0% loss.

Prior to June 30, 2010, the fund did not have a quality mandate. On that date it switched to the S&P 500 High Quality Rankings Index following a period of poor performance. It switched again in March 2016 to the S&P 500 Quality Index, which applies a more-transparent quantitative methodology. Invesco cited this transparency as the reason for the change. Because of these changes, the fund does not have a long record tracking its current benchmark. The back-tested performance of its index looks good, but as always, it is prudent to discount such hypothetical performance.

Fundamental View Firms that are more profitable and score well on other measures of quality have historically offered higher returns than their less-profitable and lower-quality counterparts. Cliff Asness and several other principals at AQR documented this effect in their paper, "Quality Minus Junk." They found that stocks with high profitability, high dividend payout rates, low market volatility, and low fundamental risk have historically outperformed their less-advantaged counterparts.

It is tough to square quality stocks' attractive historical performance with their seemingly attractive characteristics and below-average risk profile, which should command higher valuations and lower future returns. Investors may not have fully appreciated the long-term sustainability of these firms' profits and undervalued them. But 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. However, this fund does not take valuations into account.

The types of quality stocks that the fund targets are unlikely to offer eye-popping returns, and they could lag the market for extended periods, particularly during strong market rallies. So, they are probably not attractive to aggressive investors, which could cause them to become undervalued. These stocks should reward patient investors with a better risk/reward profile than the broader market over the long term.

Given its focus on return on equity and financial leverage, the fund’s holdings have consistently generated higher average returns on invested capital than the constituents of the S&P 500. And a larger portion of the portfolio is invested in firms with wide Morningstar Economic Moat Ratings, signifying that a firm enjoys a durable competitive advantage. The inclusion of financial leverage penalizes firms that generate high return on equity through debt.

Targeting stocks with low net asset growth during the past year (which the index labels an accruals ratio) tilts the portfolio toward firms with conservative capital expenditures and higher free cash flow. That said, it would be better if the fund's index applied a longer measurement window for this metric to smooth out year-to-year fluctuations.

While the fund delivers exposure to quality stocks, it introduces active bets that aren’t perfectly correlated with quality. It tends to have a growth tilt, which isn’t surprising as the highly profitable firms it owns tend to command premium valuations. And in contrast to its close competitor, iShares Edge MSCI USA Quality Factor ETF QUAL, this fund does not constrain its sector weightings or make any sector-relative adjustments in its selection criteria. As a result, it has greater exposure to industrial and consumer defensive stocks than the S&P 500 and less exposure to the healthcare, energy, and telecom sectors.

Portfolio Construction The fund employs full replication to track the S&P 500 Quality Index, which accurately represents the quality investment style. This transparent, well-crafted index targets stocks that should provide better downside protection than the market and offer better risk-adjusted performance over the long term. It warrants an upgrade to a Process Pillar rating of Positive from Neutral.

To construct the fund's benchmark, S&P assigns a composite quality score to each stock in the S&P 500 based on its return on equity, financial leverage (total debt/book value of equity), and net operating asset growth during the past year, divided by average net operating assets. S&P calls the last metric an accruals ratio, and a lower value is associated with higher quality. It ranks the members of the S&P 500 on the composite quality score and selects the top 100 for inclusion in the quality index. Qualifying stocks are weighted according to both their market cap and the strength of their quality characteristics, subject to a cap of 5%, or 20 times their market-cap weighting. The fund's index applies a buffer rule to mitigate unnecessary turnover, which should help reduce transaction costs. However, turnover was still 60% in the most recent year. The index reconstitutes semiannually in June and December.

Fees Invesco cut the fund's expense ratio to 0.15% from 0.29% in August 2018 to match QUAL. This cut is good for investors and makes this one of the cheapest quality funds available. It earns a Positive Price rating. Over the trailing 12 months through November 2018, the fund lagged its benchmark by 26 basis points.

Alternatives The closest alternative is iShares Edge MSCI USA Quality Factor ETF QUAL, but in contrast to SPHQ, it targets stocks with strong quality characteristics relative to their sector peers. QUAL then matches its sector weightings to those of the broad, market-cap-weighted MSCI USA Index to help investors avoid unintended sector bets. This sector-relative approach improves comparability but can also cause the fund to own some names with lower absolute quality characteristics than it otherwise would. Similar to SPHQ, it weights its holdings according to both the strength of their quality characteristics and their market capitalization.

Fidelity Quality Factor ETF FQAL (0.29% expense ratio) also targets the highest-quality stocks within each sector, based on free cash flow margins, stability, and return on invested capital. It weights its holdings using a combination of market cap and an equal active weighting applied to all holdings within each sector. Like QUAL, FQAL matches the sector weightings of its starting universe at reconstitution.

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.

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