Oh, Quality, Where Art Thou?

Highlighting the reduced upside but full downside capture of quality ETFs

January 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Quality and quality income ETFs have underperformed the S&P 500 since 2005
  • The most recent underperformance is explained by an underweight to technology stocks
  • However, more importantly, quality ETFs have not reduced drawdowns during stock market crashes

INTRODUCTION

Investing is never easy, but it is sometimes easier. Buying US government bonds at 10%+ yields when inflation was steadily decreasing in the 1980s was probably less worrying than buying them today at practically zero yields. In today’s world, bonds have largely lost their purpose in asset allocation, although they still constitute a large proportion of investors’ portfolios.

Increasing the allocation to equities seems the only choice for most investors, leaving alternatives like private equity aside. However, the outlook for equities is also not rosy given high valuations in the US and poor demographics in most developed and many emerging markets. Economic growth depends on healthy demographics. And there is also the rising amount of debt in society, which is bound to have negative consequences at some point.

The most frequent argument to escape this dire outlook is to focus on high-quality companies that feature sustainable growth, defensible business models, high profitability, and low leverage. Intuitively, this advice might seem sound, until pondered upon further. Such great stocks are likely to be expensive as they are highly appealing to most investors. And high profit margins tend to be disrupted by new market entrants (read Quality Factor: How To Define It?).

Although we can not forecast how high-quality stocks will perform in the future, we can certainly evaluate their historical performance. In this short research note, we will evaluate high-quality companies through the lens of quality-themed ETFs in the US.

THE GROWTH IN ASSETS OF SMART BETA QUALITY ETFS

We focus on all quality ETFs in the US, which broadly come in two flavors: pure quality and quality income. The stock selection process varies significantly across ETF issuers as there is no standard definition for quality. Howe