‘Quality’ ETF’s have unique sensitivities to the Business Cycle

Insights– AlphaPredictor Series

‘Quality’ ETF’s have unique sensitivities to the Business Cycle

Since we have heard a lot of talk about investing in ‘quality’ lately from active managers and many rules-based ‘quality’ ETFs have been launched over the last decade as well, I thought it would be interesting to analyse the largest and most popular quality UCITS ETFs just as Parala does when selecting ETFs for its client portfolios and share our findings.

We include ETFs spanning quality income, quality dividend, quality dividend growth and the quality factor in our analysis as otherwise we would be limited to evaluating several ETF providers with products tracking the same index which would not make for interesting reading to say the least. Everyone knows quality when they see it, but definitions of it vary

We have all heard interviews with fund managers playing the ‘quality’ card when asked difficult questions during TV and radio interviews. Here are a few examples, that probably sound familiar:

• “With the high level of uncertainty what should are listeners invest in? Well Jim, you really need to be focused on ‘quality’.”
• “Your firm had a tough 2020, 2021 and 2022 performance-wise, can you explain some of the reasons to our listeners? Well Jim, we focus on ‘quality’ investing and the market rewarded [fill in the blank with whatever is outperforming at the time].

Investing in ‘quality’ companies is certainly both a worthy and defensible approach. However, the term ‘quality’ is somewhat subjective as it may include any or all combinations of:

• Sustainable business models and competitive advantages
• Stable to growing earnings or dividends
• High return-on-equity
• Low leverage and strong balance sheets


Academic research has been supportive for investor interest

Factor indices have proliferated over the past decade supported by academic research. In 2015, a paper entitled A Five-Factor Asset Pricing Mode by professors Fama and French was published in the Journal of Financial Economics that expanded their three-factor model to include two quality-based factors (profitability and investment).

Several index providers launched quality indices around the same time and index-linked quality ETFs were launched shortly thereafter some of which have garnered significant assets.


ETFs in our analysis

The ETFs included are listed in Chart 1. The assets in the US listed ETFs with the same indices are substantially larger. For example, the US-listed iShares quality ETF has assets of $36.2bn.


Active risk

Even though these quality-focused ETFs are passive investments, they have significant levels of tracking error to the market benchmark represented by the S&P 500.

Active risk is not a bad thing. It can be a good thing. It is important to understand the level of active risk so that reasonable risk limits can be imposed if using these quality-focused ETFs within a portfolio which is measured against a benchmark.

These ETFs track indices with different selection and weighting methodologies which naturally lead to different levels of tracking error. This is important to understand when setting expectations around their benchmark relative performance.

For example, the iShares MSCI USA Quality Dividend ESG ETF has the highest tracking error and the iShares Edge MSCI USA Quality Factor ETF has the lowest tracking error. By January 2024, using a three-year lookback window, the tracking error of the iShares MSCI USA Quality Dividend ESG ETF was 7.6% indicating that it might over/underperform the S&P 500 by this amount on an annualised basis (see Chart 2).


Different market beta, size and style premium exposures

The quality-focused ETFs in our analysis have very different beta and risk premium exposures which help explain differences in their performance. The iShares Edge MSCI USA Quality Factor and UBS Factor MSCI USA Quality ESG ETFs have a negative exposure to the value premium which helps explain why they performed better than the quality income and quality dividend ETFs in 2023.

On the other hand, 2022 was a down year for the market and value outperformed growth and the three quality income and quality dividend ETFs, which all have positive exposure to the value premium, outperformed. The Wisdom Tree ETF has the highest exposure to momentum among the group (see Chart 3).


Returns are sensitive to changes in business cycle variables

When evaluating the risk and return behaviour of these six popular quality-focused UCITS ETFs, Parala’s model captured not only each ETF’s exposure to four important risk factors including market beta, small cap, value and momentum risk premiums but also the fact that the performance of the risk factors themselves are sensitive to the business cycle.

Each ETF also has an important residual component of its return which is independent to the risk factors but is correlated with the business cycle and may be due to differences in each ETF’s sector weights and security selection and weights within each sector.

We can identify these relationships using important macroeconomic variables like the default spread, term spread, short-term interest rate, dividend yield, VIX index and commodity prices.

Based on their sensitivities to these macroeconomic variables, we can gain additional insights into their likely behaviour across the business cycle. For example, the Fidelity US Quality Income ETF is the only ETF with a positive sensitivity to the default spread. If the default spread were rising, we would expect the performance of the Fidelity US Quality Income ETF to benefit.

Notice that the iShares MSCI USA Quality Dividend ESG ETF is the only ETF with a positive sensitivity to the short rate. In a rising rate environment, this fund would be the least negatively affected given its small positive sensitivity whereas the WisdomTree US Quality Dividend Growth ETF would be the most negatively affected (see Chart 4).


Conclusion

Everybody knows quality when they see it but there is no one-size-fits-all definition. Each of these quality-focused ETFs represents a different approach to quality investing including:
• Attempting to provide exposure to a ‘pure’ quality factor
• Quality dividends
• Quality dividend growth
• Quality income
• Combining exposure to a ‘pure’ quality factor with ESG criteria
• Combining exposure to quality dividends with ESG criteria

The result is that investors have a choice of a range of quality-focused ETFs with different expense ratios (from 20 basis points to 35 basis points) and different levels of active risk (tracking error) relative to the market index which should be understood both to establish risk limits within a portfolio context and to set expectations around potential over/underperformance.

Furthermore, due to the different types of quality these ETFs represent, they have different market beta, small cap, value and momentum premium exposures which explain differences in their historical performances and provide insights about how they might behave in different market environments.

Lastly, these ETFs have their own unique business cycle sensitivities which our model was able to identify which can be used to form performance expectations given changes in important macroeconomic variables while helping clients select funds that align with their ‘house’ views.

Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. Although endeavours have been made to provide accurate and timely information, we cannot guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No individual or company should act upon such information without receiving appropriate professional advice after a thorough review of their particular situation. We cannot accept responsibility for any loss as a result of acts or omissions.

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