Everyone Talks about “Quality” Funds, but What Does That Even Mean?

Head of Equity Strategy
Follow Jeff Weniger
07/20/2021

Our industry likes to toss around terms that strike different thoughts in different people. 

Just look at the “growth” and “value” investing styles. What are we growing these days? Earnings? Revenues? The customer base?

For valuations, some may want low P/E ratios, others high dividend yields, while maybe the “right” answer is some combination—or different measures altogether.

So it is with quality

As it applies to stocks, what does that word mean? To boil it down: a smart beta quality screen is for investors who want highly profitable companies that manage to pull it off without a mountain of debt.

The oft-cited profitability metric is return on equity (ROE), while the debt part is sometimes found by checking how the company  stacks up in the context of return on assets (ROA). If ROA is low and ROE is high, we know how the firm achieves it: management gooses the balance sheet with debt. You can minimize the goosing by explicitly incorporating ROA into a smart beta screen, which is something we do in a bunch of our Funds.

Figure 1: Definition of Quality, by Index Provider

Figure 1_Definition of Quality by Index Provider

The intellectual framework for ROE is intuitive. Look for three things: business strength, stability and operational efficiency. Each is in the DuPont equation, which shows how quality—or ROE—is simply the interaction between profit margins, business efficiency and balance sheet risk (figure 2). 

Ideally, achieving high ROE with low leverage is the way to go.

Figure 2: DuPont Equation for ROE

Figure 2_DuPont Equation for ROE

The problem: while this is great in theory, quality strategies have been disappointing in recent market declines. Take a look at what happened in five of the last nine swoons in the S&P 500 (figure 3).

Figure 3: Quality Stocks’ Struggles

Figure 3_Quality Stocks Struggles

For definitions of terms in the table, please visit the glossary.

Not only that, but quality has been lagging in this 15+ month market moon shoot. Sure, you could have bigger problems in life than watching the S&P 500 Quality index go up “only” 95.6% since March 23, 2020. Nevertheless, that is 4 percentage points short of the 99.7% run in the S&P 500 off the COVID-19 lows.

It’s showing up in valuations. According to Bank of America’s quant team, we have not seen high quality stocks this cheap relative to low quality peers in over a decade (figure 4). 

Figure 4: High Quality (B+ or better) S&P Quality Ranks vs. Low Quality (B or worse) Fwd. P/E Relative to BofA Universe (1986–5/31/21)

Figure 4_High Quality SP Quality Ranks vs. Low Quality Fwd. PE Relative to BofA Universe

Though low quality has been running higher as the COVID-19-inspired economic depression transitioned to early recovery, one of these days we will enter the middle of the economic cycle—if that stage is not already here. The impulse to buy anything and everything, with little regard for operational efficiency, should seemingly fade as the clock ticks. That environment would enable quality concepts to claw out of this tunnel of frustration.

Here is a sample of our U.S. equity mandates, sorted by ROE. Many of them are clocking in higher than the S&P, with lower P/E ratios. Use this as a hunting ground for upping portfolio quality metrics.

Figure 5: Quality Spectrum

Figure 5_Quality Spectrum

Related Blogs

Quality 101: What it Is and Why it Works

Related Funds

WisdomTree U.S. Quality Dividend Growth Fund

WisdomTree U.S. LargeCap Dividend Fund

WisdomTree International Hedged Quality Dividend Growth Fund

WisdomTree International Quality Dividend Growth Fund

For more investing insights, check out our Economic & Market Outlook

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About the Contributor
Head of Equity Strategy
Follow Jeff Weniger
Jeff Weniger, CFA serves as Head of Equity Strategy at WisdomTree. Jeff has a background in fundamental, economic and behavioral analysis for strategic and tactical asset allocation. Prior to joining WisdomTree, he was Director, Senior Strategist with BMO from 2006 to 2017, serving on the Asset Allocation Committee and co-managing the firm’s ETF model portfolios. Jeff has a B.S. in Finance from the University of Florida and an MBA from Notre Dame. He is a CFA charter holder and an active member of the CFA Society of Chicago and the CFA Institute since 2006. He has appeared in various financial publications such as Barron’s and the Wall Street Journal and makes regular appearances on Canada’s Business News Network (BNN) and Wharton Business Radio.