A Quality Decade for International Equities

Growth has outperformed value globally for the last decade. It’s been a significant headwind for rules-based (“quant”) strategies targeting less expensive stocks.

During this rough period, quants have paid increasing attention to “quality” companies.

Quality has a variety of definitions—as should all robust factors—but typically includes measures of profitability and leverage.

By screening profits, quality is closely related to growth, providing a good hedge to value or an attractive overlay to a value-tilted strategy¹.

Due to the strong performance of quality strategies—and the resilience of the factor during times of market volatility—capital has flowed into quality-focused funds this year.

WisdomTree has been an industry leader: Our currency-hedged approach to quality in broad developed international ranks in the top 5% of its Morningstar category since its inception.²

Quality Outperformance in Developed International Markets

A lot of factor discussions are U.S.-centric, but quality has had a significant performance advantage in developed international markets.

Below, we chart the performance of the first and fifth quintiles of constituents from the MSCI EAFE Index scored by a combination of return on equity (ROE) and return on assets (ROA). ROE is a good measure of the profits generated on the capital provided by common stockholders, while including ROA provides a check on the leverage financing that may be juicing ROE.

The highest quality quintile outperformed the lowest by nearly 500 basis points (bps) annualized, and at 274 bps of lower volatility.

MSCI EAFE Quintiles of Return on Equity and Return on Assets (5/31/09-5/31/19)

A cap-weighted index gives no consideration to fundamentals like profitability in its composition. The Financials sector dominates the MSCI EAFE Index, with nearly a 19% weight, due to the market having over 100 mid-sized national banks that are fighting for market share and profitability.

The WisdomTree Quality Approach

Five years ago, WisdomTree launched the WisdomTree International Hedged Quality Dividend Growth Fund (IHDG). It screens for quality dividend-paying companies. The main measures for quality are trailing three-year ROE and three-year ROA. The result is a Fund that has had, on average, about twice as high a ROE than the MSCI EAFE Index.

Return on Equity (5/31/14 – 5/31/19)

As of May 31, 2019, the Fund held just under 4% of its weight in Financials. Its biggest sector over-weights are in Consumer Discretionary, Industrials, Health Care, and Information Technology.

Since its inception, IHDG has outperformed the average returns of its peers in the Morningstar Foreign Large Growth Category, as well as both the MSCI EAFE Local Currency and MSCI EAFE Indexes.

Part of this outperformance is explained by its currency hedge during a strong dollar environment—evident by the outperformance of the MSCI EAFE Local Currency Index over the unhedged MSCI EAFE Index. But it has also benefited from its over-weight to quality companies.

For definitions of terms in the chart, please visit our glossary.

Conclusion

Many U.S. investors actively monitor factor exposures for their domestic equity allocations, but then default to an unhedged market cap-weighted allocation or unhedged active manager for their international exposure.

We have long argued the merits of at least partial hedging in international equities, in order to improve the risk-return profile by mitigating some of the embedded currency bet. And just as investors are familiar with harvesting the quality risk-premium in U.S. equities in a rules-based ETF, we would argue investors should consider doing so in developed international markets as well.

¹Novy-Marx, Robert. (2013). “The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics, 108, issue 1, p. 1-28.
²Sources: Morningstar, WisdomTree, 5/31/14-3/31/19. Inception date for IHDG was 5/7/14. There are 320 investments included in peer group for Morningstar Foreign Large Growth. The percentile rank is the funds' total-return percentile rank compared to all funds within the same Morningstar category and is subject to change each month. There are 320 investments included in peer Foreign Large Growth Category , for since inception performance, 5/31/14-3/31/19. For the one year period as of 3/31/19 the fund is in the 7 rank out of 442 funds.