HOW SHOULD THE QUALITY FACTOR BE DEFINED?
The concept of quality in many asset classes is not new, but its application to equity selection has gained traction in the last few years. Quality can help meet investment objectives as a single factor or in combination with other factors. Intuitively, it makes sense that high-quality companies should have better overall performance than low-quality companies. Unfortunately, however, unlike other equity factors such as value or size, there is no generally accepted definition of quality.
Often, the quality metric is simply related to some measure of profitability. Many asset managers include quality in a multi-metric definition, for example, combining return on equity,1 debt-toequity ratio2 and earnings variability.3 Or, as in the Russell U.S. Equities Indices, return on assets plus leverage plus earnings variability. Another variation is the F score, developed by Joseph Piotroski. It combines nine metrics, including net income, operating cash flow, return on assets, stability of earnings, leverage, liquidity issuance, gross margins and asset turnover. The issue is hotly debated and there are countless methodologies in the marketplace.
Interestingly, in its continuing research of the quality factor and how to apply it in a scoring methodology, FlexShares’ parent company, Northern Trust , concluded that “quality” includes those features of a company that particularly appeal to risk-averse investors. Further, their empirical evidence has shown that the higher returns of high-quality companies have, in fact, been associated with considerably lower levels of risk. If that seems counter-intuitive to the most widely used pricing model in finance–the Capital Asset Pricing Model (CAPM)4 – that’s because it is.
CAPM assumes universal risk aversion on behalf of investors. That’s not actually the case with human behavior. Investors are heterogeneous. The risk averse seek low-volatility stocks in search of “peace of mind.” As quality erodes, risk increases. High-volatility stocks are most attractive to risk-seeking investors, who bid up the price of these lower-quality equities and consequently reduce their returns. The result: high-quality stocks typically outperform low-quality names because lowquality/high-volatility names are relatively expensive versus high-quality/low-volatility names.
Given the extremely volatile market environment, we cannot over-emphasize the importance of the quality factor in choosing equities that can survive and even thrive
HOW DOES FLEXSHARES JUDGE QUALITY?
High-quality companies exhibit certain characteristics. The FlexShares quality scoring process includes detailed assessments of each company compared to its peers, using fundamental factors that are empirically tested, supported by academic research and applied quantitatively.
Below are the pillars of our methodology.
- Management efficiency: a quantitative evaluation of a firm’s deployment of capital as well as its financing decisions. Research shows firms that aggressively pursue capital expenditures and additional financing lose flexibility in both advantageous and challenging portions of the market cycle.
- Profitability: a determination of a firm’s relative competitive advantage across several different metrics. Firms with wider margins are better positioned to grow compared to firms with slimmer margins.
- Cash flow: an assessment of the liquidity levels of the company. A firm that cannot meet its debt obligations and day-to-day liquidity needs will be poorly positioned to take advantage of future opportunities or provide a financial cushion during periods of distress We apply this methodology to companies on a sector basis in order to:
- Provide an “apples-to-apples” comparison, since different sectors — such as utilities and technology companies — vary considerably in how they profile;
- Find quality companies in every sector without concentrating in certain pockets of the market; and
- Prevent unintended stock selection and weighting biases caused by a dramatic sector drift from the starting universe.
The result is a growing body of ETF products that can appeal to risk-averse investors and may help them achieve stronger risk-adjusted returns through the most turbulent of market environments.
Eight of our 22 ETFs have the word “Quality” in their name. For more information please visit us here.
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