Benefits of Quality Apparent During Volatile Q3
We’ve written a lot recently about what it means to focus on quality in equity investments. The third quarter of 2015—with the volatility that it brought along with it—provided what we think was an interesting short period to illustrate the benefits of a quality approach.
Bottom Line: Quality as a factor has historically worked best during volatile periods, and this third quarter was a prime example.1
MSCI EAFE Quality (EAFE Quality) and EAFE (EAFE Broad) Indexes, both measured in local currency terms, illustrate over a long period of analysis how this played out across time—back to December 1, 1975. We looked at rolling periods three months, six months, 12 months and 36 months in duration.
Importantly, we focused our analysis on times when EAFE Broad exhibited a negative return, zeroing in on periods where performance was a bit more challenging, like what we saw in the third quarter of 2015. We also looked at median returns for these different periods, so as to mitigate the risk of outliers influencing the picture.
Median Performance in Down Markets over Specified Rolling (3-, 6-, 12- & 36-Month) Periods from 12/1/1975 to 9/30/2015
At a high level, based on what we see in the chart, there was median outperformance of EAFE Quality over EAFE Broad over each of the rolling period frequencies—3, 6, 12 and 36 months—when the return of EAFE Broad was negative.
• Big Declines of 5% or More: Digging a little deeper into the three-month analysis, since we began our focus talking about the third quarter of 2015, there were actually 70 three-month periods from December 1, 1975, to September 30, 2015, in which the returns for the MSCI EAFE Index declined more than 5%.
• Median outperformance of EAFE Quality in those periods was approximately 3%, while in all other periods the median differential was essentially zero.
• Looking again a bit further at the rolling three-month analysis, there were 126 three-month periods in which returns for EAFE Broad declined more than 1%. Median outperformance of quality in those periods was close to 2 percentage points, while in all other rolling three-month periods, the median differential was negative 18 basis points (bps) , meaning that EAFE broad slightly outperformed EAFE Quality during positive environments.
• This research suggests quality as a factor had some of its best returns for the EAFE universe during down markets, declining less than EAFE Broad.
The Third Quarter of 2015
Now that we know our expectations of how quality might perform in difficult markets, it’s time to look at the third quarter of 2015. Importantly, the WisdomTree International Hedged Quality Dividend Growth Fund (IHDG) tracks the performance of the WisdomTree International Hedged Quality Dividend Growth Index before fees and expenses. This Index represents WisdomTree’s approach to quality in the developed international equities.
• In Q3, the EAFE Broad was down nearly 9%, but IHDG was down merely 4.8%. This is approximately 4.2% outperformance. EAFE Quality also outperformed EAFE Broad by more than 5 percentage points. Median outperformance of EAFE Quality over EAFE Broad when EAFE Broad was negative was closer to 1.5%, so this represents a significant period, in our view.
• Broadening to the year-to-date 2015 period, we see that EAFE Broad delivered a negative return of nearly 1.0%. EAFE Quality was up 2.0%, and IHDG was up nearly 4.1% over this same time frame.
While we recognize that this was just one single three-month period (as well as one single year-to-date nine-month period), we still believe it to be worth noting. If people think markets could continue to exhibit volatility similar to what was seen in the third quarter of 2015, we think that looking toward quality should be of particular interest.
1Source: Bloomberg, as of 9/30/15.
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