Quality ETFs
A quality ETF is a so-called "smart beta" ETF that select stocks based on one or more measures as to whether the company is a "quality" company. Although there is not necessarily a hard and fast rule, a quality company is typically considered to be a profitable company with high earnings. Some people will also imply that to be a quality company, a company must have a "good balance sheet" or be "fundamentally sound", but at stoxray.com, when we talk about the quality factor, we are referring to any ETF that selects stocks using one or more measures of the earnings of a company.
How do you measure whether a company is a profitable company? Various quality indexes are using a wide variety of methods to measure a company's earnings:
- Net income
- Return on equity, which is a company's net income as a percentage of the company's stockholders' equity
- Return on assets, which is a company's net income as a percentage of the company's total assets
- Free cash flow, which is typically how much of a company's net income is left over after debt service
Academic factor research has usually concluded that quality is one of the significant factors that can lead to one company's stock outperforming the market. Fama French measured quality by looking at a company's net operating income. Hou Xue and Zhang measured quality using a company's return on equity.
Here are the quality ETFs that only use quality as an investment factor (i.e. they are not multi-factor ETFs), if you want to read some examples of the approaches taken by quality ETFs:
| Name | Symbol | Last price | Currency |
|---|---|---|---|
| PACER US EXPORT LEADERS ETF | ARCX:PEXL | 48.49 | USD |
| iShares Edge MSCI Multifactor USA Small- | ARCX:SMLF | 68.24 | USD |
| Columbia U.S. Equity Income ETF | ARCX:EQIN | 44.40 | USD |
| SPDR MSCI USA Quality Mix ETF | ARCX:QUS | 155.68 | USD |
| JPMORGAN US QUALITY FACTOR | ARCX:JQUA | 57.99 | USD |
| FlexShares Intl Quality Div Index | ARCX:IQDF | 23.12 | USD |
| ETRACS 2x Leveraged MSCI US Quality Factor TR ETN | ARCX:QULL | 48.48 | USD |
| Nuveen Growth Opportunities ETF | ARCX:NUGO | 35.22 | USD |
| SPDR MSCI Emerging Market Qualty Mix ETF | ARCX:QEMM | 57.66 | USD |
| WisdomTree US SmallCap Earnings Fund | ARCX:EES | 53.90 | USD |
| WisdomTree US MidCap Earnings Fund | ARCX:EZM | 62.81 | USD |
| Flxshs Intl Quality Div Defensive Index | ARCX:IQDE | 20.35 | USD |
| Invesco S&P 500 Quality ETF | XNYS:SPHQ | 67.90 | USD |
| SPDR MSCI World Quality Mix ETF | ARCX:QWLD | 123.94 | USD |
| FlexShares US Quality Large Cap Index Fd | BATS:QLC | 66.94 | USD |
| SPDR EURO STOXX Small Cap ETF | ARCX:QEFA | 72.32 | USD |
| iShares Edge MSCI USA Quality Factor | BATS:QUAL | 179.43 | USD |
| iShares Edge MSCI Intl Quality Factor ET | ARCX:IQLT | 37.06 | USD |
| VictoryShares Free Cash Flow ETF | XNAS:VFLO | 33.90 | USD |
| AMERICAN CENTURY STOXX US QL | ARCX:QGRO | 101.43 | USD |
| Virtus Terranova U.S. Quality Momentum ETF | XNAS:JOET | 38.41 | USD |
| INVESCO INV GRADE DEFENSIVE | ARCX:IIGD | 24.27 | USD |
| WisdomTree US Earnings 500 Fund | ARCX:EPS | 61.91 | USD |
| FlexShares Global Quality Real Estate | ARCX:GQRE | 56.61 | USD |
| Columbia Emerging Markets Consumer ETF | ARCX:ECON | 20.95 | USD |
| Matthews International Funds Matthews Asia Dividend Active ETF | ARCX:ADVE | 32.17 | USD |
| WisdomTree Trust WisdomTree U.S. Quality Growth Fund | ARCX:QGRW | 50.04 | USD |
| ETC 6 Meridian Quality Growth ETF | ARCX:SXQG | 31.99 | USD |
| iShares Edge MSCI Multifactor Global ETF | ARCX:GLOF | 43.57 | USD |
| WisdomTree International Quality Dividen | BATS:IQDG | 34.58 | USD |
| Invesco International Developed Dynamic Multifactor ETF | BATS:IMFL | 23.59 | USD |
| Natixis ETF Trust Natixis Gateway Quality Income ETF | ARCX:GQI | 54.89 | USD |
| Pacer US Large Cap Cash Cows Growth Leaders ETF | XNAS:COWG | 32.88 | USD |
| SEI EXCHANGE TRADED FDS SEI Enhanced U.S. Large Cap Quality Factor ETF | BATS:SEIQ | 35.53 | USD |
| Pacer US Small Cap Cash Cows Growth Leaders ETF | XNAS:CAFG | 25.79 | USD |
| Flxshs Intl Quality Div Dynamic Index Fu | ARCX:IQDY | 27.54 | USD |
| Fidelity Quality Factor | ARCX:FQAL | 65.84 | USD |
| J.P. Morgan Exchange-Traded Fund Trust JPMorgan Active China ETF | ARCX:JCHI | 44.85 | USD |
| FlexShares Quality Dividend Index Fund | ARCX:QDF | 70.98 | USD |
| Flexshr Def Qul | ARCX:QDEF | 70.59 | USD |
| American Century STOXX U.S. Quality Value | ARCX:VALQ | 61.52 | USD |
| PowerShares S&P SmallCap Quality Portfolio | XNYS:XSHQ | 42.92 | USD |
Do quality ETFs outperform?
In general, it is very difficult to reach conclusions about smart beta ETFs because they use so many different approaches to selecting and weighting stocks. Literally, no two smart beta ETFs seem to be the same. And they have such limited history. Quality ETFs, in particular, are using a lot of different approaches to selecting "quality" stocks.
As a stand-alone factor, the quality factor can lead to some outperformance, although it is not always dramatic. Let's look at a few examples.
EPS, the WisdomTree Earnings 500 Fund ETF, seems to be screening and weighting stocks using the classic definition of a "quality" company - companies with high core earnings. Yet it doesn't seem to make a difference, as EPS and SPY are closely correlated.
EZM, the WisdomTree MidCap Earnings Fund ETF, screens and weights stocks using core earnings, but it only includes mid cap stocks in its index. It has slightly outpeformed MDY, which tracks the S&P Mid cap 400 Index:
EES, the WisdomTree SmallCap Earnings Fund ETF, screens and weights stocks using core earnings, but it only includes smallcap stocks in its index. It has slightly outpeformed IJR, which tracks the S&P Smallcap 600 Index:
Conclusion
The evidence to date is not very convincing that the quality factor by itself plays a huge role in picking stocks. EES and EEM seem to indicate that picking stocks based on the company's earnings helps, particularly in the case of mid and small cap stocks, but the evidence is not overwhelming. Said another way, there hasn't been an ETF invented yet that has been able to significantly outperform the major indexes merely by screening for profitable companies.