ETF Spotlight: MSCI USA Quality Factor ETF (QUAL)

by on October 14, 2014

Over the years, ETFs have become one of the most popular tools for investors looking to build cheap, efficient, and diversified portfolios. While there are several more “exotic” and hyper-targeted options, the most popular funds are still those that feature broad-based exposure – the core,  “plain vanilla” products. The iShares brand is well known for providing core exchange-traded funds, which are designed to be used as building blocks for investor portfolios. One of its funds, however, aims to put a twist on the traditional core portfolio: the MSCI USA Quality Factor ETF (QUAL).

Inside QUAL’s Strategyquality

The MSCI USA Quality Factor ETF (QUAL) is based on one of the most popular domestic equity benchmarks: the MSCI USA Index. QUAL, however, differs from the traditional market capitalization-weighted index by putting a unique twist on this benchmark. The MSCI USA Quality Index focuses on only those equities that have exhibited positive fundamentals. These main “quality factors” include a high return on equity (ROE), stable year-over-year earnings growth, and low financial leverage. 

The investment thesis behind this strategy is that companies that exhibit these factors are historically those that have shown strong and stable returns. Furthermore, these companies also tend to exhibit relatively low levels of volatility as compared to their “non-quality” counterparts. 

Under the Hood of QUAL

After screening the MSCI USA Index based on the three main quality factors, QUAL’s resulting portfolio is comprised of roughly 126 individual holdings. In comparison, the MSCI USA Index holds about 620 stocks, meaning the screening methodology significantly narrows the scope of the domestic equity universe. 

Getting a bit more into details about the index construction, the 126 screened stocks are all given a “Quality Z-score,” which is derived by comparing the stock’s three quality variables to the averages of the MSCI Index. Each stock’s Quality Z-score is then multiplied by each stock’s original market capitalization weight, which is then used to determine the stock’s final weight in the index [see 10 Questions About ETFs You've Been Too Afraid To Ask]. 

Given QUAL’s index screen criteria, it may not be surprising to see that the fund’s top five holdings include some of the largest and most well-known names on the market: Apple (AAPL), Microsoft (MSFT), Johnson & Johsnon (JNJ), Exxon Mobil (XOM), and International Business Machines Corp (IBM). Each of these companies receives an allocation of roughly 5.0%. The rest of the portfolio also features well-known companies; roughly 60% of total assets are allocated to giant-cap stocks, and about 25% to large-cap. 

From a sector perspective, QUAL’s portfolio exhibits a slight bias towards technology equities, which comprise roughly one-third of total assets. Significant exposure is also allocated to consumer cyclical, healthcare, and industrials sectors. Getting a bit more granular, software & services, pharmaceuticals, and biotechnology stocks make up approximately 40% of the portfolio.

Considerations on QUAL PerformanceWall Street

Investors should note that generally, QUAL’s performance will be very similar to the broader U.S. equity market. The fund’s risk/return profile is not much different than a fund like SPY, though the focus on fundamentaly sound companies may help mitigate downside risk during more volatile periods, as these companies are less likely to exhibit larger price swings. 

How to Use QUAL in a Portfolio

QUAL should be used as a core holding in a portfolio. It should not be used as a complement to other broad-based equity products, such as SPY. Instead, QUAL is a compelling option for those wishing to gain diversified exposure to U.S. equities, while at the same time focusing on key fundamental factors.

Furthermore, this type of core holding is more appropriate for traditional buy-and-hold investors, since the companies within this fund are not those that will exhibit large capital gains within a short time frame. Because of its quality factor screening methodology, QUAL focuses more on providing strong yet stable returns. 

The Bottom Line

The methodology employed by QUAL makes it one of the most compelling core ETFs on the market. For any buy-and-hold investor that likes to focus on fundamentals- such as a high return on equity (ROE), stable year-over-year earnings growth, and low financial leverage – QUAL is a cheap, efficient, and easy option that provides this popular investment strategy in a single ticker. 

Follow me on Twitter @DPylypczak

[For more ETF analysis, make sure to sign up for our free ETF newsletter]

Disclosure: No positions at time of writing.