Factor Exposure Analysis 112: Quality vs Growth Factors

What equity factors should be used in a factor exposure analysis?

March 2025. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The number of independent factors in a factor exposure analysis is subjective
  • Typical quality metrics often are unrelated, so should not be combined
  • There is also merit in including the growth factor, even if it does not offer positive excess returns

INTRODUCTION

The Fama-French 3-Factor Model was introduced in 1993 in the paper “Common Risk Factors in the Returns on Stocks and Bonds” by Eugene F. Fama and Kenneth R. French, published in the Journal of Financial Economics. This model incorporated three factors: the market, size, and value factors. In 2015, Fama and French expanded their model by adding the profitability and investment factors.

Despite these models being widely used as standards for evaluating fund and portfolio performance, challenges remain. For instance, Jegadeesh and Titman (1993) introduced the momentum factor, while Zhang (2021) proposed the q-factor model, highlighting the ongoing evolution of asset pricing research.

Given this complexity, portfolio analysis firms like MSCI, Bloomberg, or Finominal utilize different factor sets for exposure analysis. Our approach focuses on keeping equity factor selection simple and practical, incorporating value, size, momentum, low volatility, and quality. However, analyzing quality funds has been particularly challenging when applying a multi-metric approach. Additionally, we include a growth factor for evaluating growth-oriented funds (read Factor Exposure Analysis 102: More or Less Independent Variables?).

In this research article, we will examine the quality and growth factors within the context of factor exposure analysis.

QUALITY FACTOR

We define the quality factor based on two metrics: leverage (debt-to-equity) and profitability (return-on-equity). Constructing a beta-neutral portfolio using the top and bottom 30% of U.S. stocks ranked by these metrics yields no excess returns over the past 20 years. However, when analyzed separately, profitability demonstrates positive excess returns, whereas leverage does not.<