Quality was steady among the various investment factors last year and while it may not be the outright leader this year, it is positioned to deliver for investors, indicating there’s opportunity afoot with exchange traded funds, such as the FlexShares US Quality Low Volatility Index Fund (QLV).
QLV follows the Northern Trust US Quality Low Volatility Index. The ETF’s benchmark employs a quality screen to provide exposure to high-quality companies with lower absolute risk, thereby limiting potential future volatility. The quality screen analyzes a broad universe of equities based on key indicators such as profitability, management efficiency, and cash flow, and then excludes the bottom 20% of stocks with the lowest quality score. The index is then subject to the regional, sector, and risk-factor constraints, in order to manage unintended style factor exposures, significant sector concentration, and high turnover.
Some market observers are bullish on quality for 2021.
“Quality assets with strong balance sheets and cash flows also offer resilience against potential bumps on the road to a full activity restart, in our view. We maintain our overweight in the quality style factor – a view that worked out well throughout 2020,” according to BlackRock research.
Betting on Quality in 2021
Quality has historically outperformed other investment factors during economic slowdowns, but that thesis could be challenged if quality ETFs amass large positions in cyclical sectors, such as tech.
Historical data confirm that the quality factor wins over the long-term as the most profitable companies have easily outpaced their less profitable peers by significant margins over longer holding periods. QLV’s benefits are on display this year.
Valuing high quality value is particularly important as bull markets enter their waning stages, as some market observers believe the current bull market is doing. In the early stages of bull markets, lower quality companies see their shares soar. However, as the bull matures, investors often exhibit a preference for higher quality fare with more compelling valuations.
“This helps inform our barbell approach to risk assets over the next six to 12 months: quality assets such as tech and healthcare stocks on one end, and selected cyclical exposures on the other,” notes BlackRock.
Additionally, quality should not be conflated with low volatility, but there are times when quality stocks display low volatility traits. That was the case during the fourth quarter of last year’s market swoon, indicating that the quality factor can provide some protection during times of elevated market stress.