Insights

Insights   •   Equities

Four Reasons to Focus on Quality Quality Investing from a Factor Perspective - Part I

  • Quality is an increasingly important and effective factor in future market and economic conditions.
  • We believe that there are four reasons to focus on Quality now.
Portfolio Strategist

During the Covid-19 market turmoil and subsequent recovery, two defensive factors - Low Volatility and Quality - performed very differently. Low Volatility provided effective downside protection during the turmoil; however, it stagnated during the subsequent market upturns (see Figure 1). Quality also provided effective downside protection during market turmoil, but it showed strong market capture on the upside.

Figure 1: Performance of Quality and Low Volatility in the Covid-19 Year

four-reasons-to-focus-on-quality-figure1.png

This paper provides four key reasons for investors to focus on Quality now. First, we look at two topics currently in the spotlight, the Value vs. Growth debate and challenges that the Minimum Volatility strategy faces. Then we discuss the effectiveness of factors from the perspective of market cycles. Finally, we cover the relationship between Quality and ESG (Environmental, Social, and Governance) investing.

1. Beyond Value vs. Growth

In an accommodative financial environment, Value stocks underperformed Growth stocks over the last decade (see Figure 2). Although the performance of Value has reversed, a sense of caution still remains. Looking at the Growth side, some names have been overpriced at the end of the liquidity-driven market rise; however, Growth stocks still have high profitability and growth expectations (see Figure 3). However, when a company’s Quality is captured in terms of its fundamentals, this provides a different perspective on the two-dimensional debate between Value and Growth.

Figure 2: Cumulative Excess Returns of Value and Growth Indexes vs. MSCI World

four-reasons-to-focus-on-quality-figure2.png

Figure 3: Quintile Fundamentals Analysis (MSCI World Ex Financial and Real Estate)

four-reasons-to-focus-on-quality-figure3.png

2. Minimum Volatility: Beyond Low Volatility

A Minimum Volatility strategy, which is often utilized in low-risk investing, has high investment efficiency (Figure 4) and strong downside protection over the long term (Figure 5). However “min-vol” has challenges such as high tracking error and under performance against a market benchmark in rising markets — as was seen in upturns after the Covid-19 turmoil. Quality is a key factor to consider in choosing any multifaceted, low-risk investment solution that enhances market follow ability.

Figure 4: Efficiency of Factor and Style Indexes (MSCI World)

four-reasons-to-focus-on-quality-figure4.png

Figure 5: Average Excess Returns of MSCI World Minimum Volatility Index

four-reasons-to-focus-on-quality-figure5.png

3. Prepare for Downside of the Business Cycle

Figure 6 illustrates the effectiveness of factors in stock market cycles, depending on economic cycles and monetary policies. Given rising interest rates and Value reversals, we are likely to be in a transitional period from a liquidity- to fundamentals-driven market. While a transition to a fundamentals-driven market and debates over tapering will bring increasing uncertainty to the market in the short term, further downsides are anticipated after monetary tightening in the medium term. This expectation makes Quality more and more important as a positioning that performs during the downside in the market cycle.

Figure 6: Effectiveness of Factors in Market Cycles

four-reasons-to-focus-on-quality-figure6.png

4. Relationship with ESG

For many investors, ESG is seen as an additional Quality lens through which to view investment strategies. In a study of the correlation of ESG characteristics with risk factors from the MSCI Global Equity Model, it was found that ESG rating score has a positive correlation with investment quality and profitability factors; the study found a negative correlation with the earnings variability, residual volatility, and book-to-price factors.1 The study also pointed out that the statistical significance of these correlations is strong over the observation period, and correlation levels are persistent and relatively stable. Another study reported that Quality and Low Volatility have superior ESG characteristic in terms of carbon reduction and ESG score improvement compared to other common smart beta factors such as Value, Size, and Momentum.2 On the back of such affinity between Quality and ESG, the expansion of ESG investment could be a tailwind for Quality.

Conclusion

There are four reasons to focus on Quality now. Quality can provide a different perspective on the two-dimensional Value vs. Growth debate; it can represent an enhanced low-risk solution when combined with Low Volatility; it is expected to be effective in the future from the perspective of the business cycle; and lastly, the expansion of ESG investment could be a tailwind for Quality. Quality is an increasingly important and effective factor in future market and economic conditions. State Street Global Advisors helps meet client investment needs by developing and implementing strategies that incorporate Quality in active and smart beta spaces.

Share