Another ETF For Lovers Of Quality Stocks

With U.S. stocks continuing to flail, investors seeking long equity exposure might want to give renewed attention to the quality factor.

Stocks with the quality designation are, broadly speaking, less volatile than their lower quality peers, dividend payers and raisers and prolific cash generators. Those traits increase the allure of an arraryof exchange traded funds that focus on the quality factor, a group that includes the $1 billion iShares MSCI USA Quality Factor ETF (NYSE:QUAL).

QUAL, which recently celebrated its second anniversary, follows the MSCI USA Sector Neutral Quality Index. That index aims to capture the performance of securities that exhibit stronger quality characteristics relative to their peers within the same GICS sector by identifying stocks with high quality scores based on three main fundamental variables: high Return-on-Equity (ROE), low leverage and low earnings variability, according to MSCI.

Although the index's name implies sector neutrality, a combined 36 percent of QUAL's weight is allocated to technology and financial services names. That is slightly less than the S&P 500 allocates to those sectors. Healthcare and consumer discretionary names combine for another 29.4 percent of QUAL's weight, slightly more than the nearly 28 percent the S&P 500 devotes to those groups.

The types of stocks the fund owns have tended to hold up a little better than average during market downturns. Strong competitive advantages help protect profits and make these firms slightly less sensitive to the business cycle than less advantaged firms, according to a new research note from Morningstar.

Indeed, QUAL has outperformed/been less bad than broader benchmarks as U.S. stocks have swooned. Over the past 90 days, QUAL is down 6.6 percent, which is better than the 8.4 percent lost by the S&P 500 over the same period.

As Morningstar notes, there are periods when stocks with the high quality designation can lag names that do not sport that label, namely during overt bull markets. However, QUAL has offered notable outperformance of the S&P 500 over the past two years, a bull market, surging 26.3 percent while the benchmark U.S. index is higher by 22.7 percent over the same span.

QUAL's emphasis on profitable companies that have durable competitive advantages and predictable earnings would seem to come at a significant valuation premium, but that is not the case.

While overpaying for quality can wipe out its benefits, the fund's holdings are currently trading at reasonable valuations. At the end of August, the fund was trading at 18.5 times forward earnings, only slightly higher than the corresponding value for the Russell 1000 Index (17.7). Based on Morningstar equity analysts' fair value assessments of the fund's underlying holdings, it is trading close to fair value, as of this writing, said Morningstar.