Buying Quality: Is The Juice Worth The Squeeze?

Investing is never easy, but some times are easier than others. Buying US government bonds at 10%+ yields when inflation was steadily decreasing in the 1980's was probably less worrying than buying them today at negative real yields. In today’s world, bonds may have largely lost their income-generating purpose, although they still constitute a large proportion of investors’ portfolios.

What is a yield-hungry investor supposed to do in this environment? Increasing the allocation to equities seems like the only choice for most investors, leaving alternatives like private equity aside.

However, the outlook for equities is also not rosy, given high valuations in the US and poor demographics in most developed and many emerging markets. Economic growth depends on healthy demographics. And there is also the rising amount of debt in society, which is bound to have negative consequences on growth at some point.

The most frequent argument to escape this dire outlook is to focus on high-quality companies with sustainable growth, defensible business models, high profitability, and low leverage. Intuitively, using our quick-reaction, i.e., “system one,” thinking style, this advice sounds rational. It isn’t until we kick in our rational brain, i.e., “system two,” where we can question seemingly simple and clear advice. Such great stocks are likely to be expensive as they are highly appealing to most investors -- and high-profit margins tend to be disrupted by new market entrants.

Although we cannot forecast how high-quality stocks will perform in the future, we can certainly evaluate their historical performance. In this short research note, we will evaluate high-quality companies through the lens of quality-themed ETFs in the US.

The Growth In Assets Of Smart Beta Quality ETFs

We focus on all quality ETFs in the US, which broadly come in two flavors: pure quality and quality income. The stock selection process varies significantly across ETF issuers as there is no standard definition for quality. However, it tends to be multi-metric approaches that include ratios like earnings stability, leverage, and profitability.

We observe that the assets under management in quality and quality income ETFs have almost doubled between 2018 and 2020. However, it is worth highlighting that the aggregate amount of assets of slightly under $30 billion represents a fraction of the capital allocated to other smart beta categories.

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Disclosure: Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past ...

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