Whats Quality Got to Do with It?
When stock investors focus on the quality factor, they are looking to identify companies with the potential for strong future cash flows, while limiting exposure to companies that are unprofitable or highly leveraged. In many ways, the attributes of quality stocks are similar to what investors expect from classic blue-chip stocks.

Because of the defensive characteristics of quality stocks, investors tend to gravitate toward them during periods of economic contraction. But in 2017—a year of economic growth and strong market performance—quality outperformed the overall market substantially. In fact, this factor has been outperforming the broad market, to a lesser degree, for the past 10 years. The underlying reasons for this outperformance offer insight into what constitutes quality today, and they also provide an indication of where investors looking to incorporate factor tilts into their portfolios may want to add exposure.

With advancements in indexing, investors can now systematically gain exposure to quality by focusing on stocks that meet certain measures of this factor, such as corporate profitability, operational efficiency, earnings quality, and financial leverage.

A Closer Look at Quality’s Performance

In 2017, the quality factor outperformed the market by a considerable amount: 638 basis points (6.38%). Exhibit 1. Since the quality factor leans toward companies with high profitability and low leverage, some may be surprised to see that it performed so well during a period of robust market performance and strong returns for growth companies. In contrast with how the factor fared in 2017, quality companies have historically performed best in periods of economic slowdowns, when investors hunker down and become more defensive.

So, how should investors interpret this recent performance?

A key driver of the strong performance in 2017 was the fact that the quality factor index includes a healthy dose of information technology (IT) stocks. IT stocks are also heavily weighted in the growth index, which also posted strong performance last year. Exhibit 2. While many think of IT as a traditional growth sector, they may not associate it with quality. But, in recent years, IT companies have offered a high return on equity, strong profit margins, and low debt-to-equity ratios— which are all classic quality characteristics.

Quality and Momentum: An Unusual Pairing

It may surprise investors that the quality factor has become highly correlated to the momentum factor, given that, historically, this has not often been the case. The momentum factor isolates on stocks that have delivered recent winning performance, especially relative to other stocks that may have recently posted lackluster or negative returns. With quality stocks having performed so well over the past few years, they have become some of the market's momentum stocks. Exhibit 3. In the last quarter of 2016, the correlation between the two factors rose as high as 0.82. After declining and even turning negative in early 2017, correlations increased again towards the end of 2017 and reached 0.58.1

Again, the preponderance of IT companies in the quality index, and their robust performance in 2017, help explain the correlation. In contrast, quality has become extremely negatively correlated with the value factor, which underperformed significantly last year. At the stock level, the quality factor index shares 8 of its top 10 holdings with the momentum factor index, but shares only one with value.2

Over time, market participants may bid up different securities, redefining “recent winners” and changing the fundamentals of the momentum factor index. Given 2017 performance, the momentum factor’s current representation of stocks offers investors exposure to a basket of companies that happen to be more defensive in nature.

Positioning for What May Lie Ahead

Given that factors provide precise definitions of the attributes that drive long-term returns, and the fact that they have a history of delivering long-term outperformance relative to the overall market, factors can help explain what impacts risk and return within a portfolio. Still, when integrating factor considerations into asset allocation strategies, investors and advisors need to remember there is no free lunch. Over the short term, factors tend to be cyclical, and they can have extended periods of underperformance.

By analyzing each factor’s current fundamental makeup, in addition to its long-term risk and return profiles, we can gain well-rounded insights into the expected investment outcome that any combination of factors in a portfolio might deliver. For those looking to employ a strategy that blends factors, today a tilt toward a pro-cyclical factor such as value combined with the momentum factor could potentially offer the flexibility to both participate in an expansionary market and maintain defensive characteristics.

Read more of our analysis in our Factor Dashboard, a monthly overview that looks at both long-term factor performance and relationships between factors, as well as short-term market movements and recent trends, to provide insight on what might be the current investment outcome for single-factor portfolios.  

  1. ^Source: Morningstar Direct, as of 12/31/17.
  2. ^Source: FTSE Russell, as of 12/31/17.