Quality Factor: Zero Alpha for Most Investors?

Factor Construction Matters

September 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • It’s difficult to rationalise why there should be excess returns from high quality stocks
  • The Quality factor needs to be constructed beta-neutral to achieve positive returns
  • Exposure to the Quality factor is an attractive hedge for an equity-centric portfolio

INTRODUCTION

The concept of investing into the Quality factor is an odd one as it’s difficult to rationalise why investors should get compensated for holding companies that are highly profitable and have solid balance sheets. Intuitively high quality stocks should be structurally expensive and the factor performance should be flat or negative, except in periods of financial crisis. It might be argued that high quality stocks outperform low quality stocks on a risk-adjusted basis, similar to the Low Volatility factor, which would require investors to manage their Quality portfolios beta-neutral. In this short note we’re going to analyse the difference between constructing the Quality factor $-neutral versus beta-neutral and the impact of adding either to an equity-centric portfolio (read Factor Construction: Beta vs $-Neutrality).

METHODOLOGY

We’re going to focus on the Quality factor in the US and Global ex-US, which includes all developed markets in Europe and Asia. We define Quality as a combination of debt-to-equity and return-on-equity, i.e. reflecting balance sheet strength and profitability. The factor is constructed as a long-short portfolio by taking the top and bottom 10% of the stock universes. Only companies with a minimum market capitalization of $1bn are considered and 10bps of transaction costs are included (read Quality Factor: How To Define It?).

The $-neutral portfolio is model-free as the long portfolio receives the same allocation in $-terms as the short portfolio, e.g. $100 each. For the avoidance of doubt, $ simply refers to a unit of currency and not to the US$. The beta-neutral portfolio is constructed by increasing the weights of stocks which have a one-year beta to the local index of below 1 and decreasing the