IQ INSIGHTS Why Quality Investing?

IQ INSIGHTS
Why Quality Investing?
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Quality Factors — The Key Metrics
PROFITABILITY is measured by net income before tax divided by
total assets (i.e. Pre-Tax Return on Assets) — a measures of how
companies use their assets to generate earnings. The rationale
here is that companies that are better at generating wealth from
their assets will be recognized by the market and rewarded with a
higher share price.
EARNINGS VARIABILITY is measured by the standard deviation of
by Taie Wang, Senior Portfolio Manager, Global Equity Beta
Solutions, State Street Global Advisors and Bruce Zhang, Portfolio
Specialist, State Street Global Advisors
Why Quality Matters
Quality investing has become increasingly popular in recent
years since evidence for the quality premium is strong and
consistent. As the investment industry becomes more familiar
with the concept of Advanced Beta, investors are reconsidering
their current active and passive allocations and looking at the
potential benefits of factor-based investing. One of the key
factors to consider is quality — defined as stocks that are
profitable, stable, and financially sound.
Quality investing aims to identify companies with superior
Earnings per Share (EPS) divided by the median earnings for
the past 5 years. This measures the volatility of EPS. Dividing
the median earnings normalises the volatility and makes it more
comparable across different companies. Also, by using a 5-year
average we remove some of the variability inherent in cyclical
high quality companies but which have more variable earnings. If
the selection was based on a shorter time frame, we could possibly
be eliminating some of those cyclical names and the resulting
portfolio would be less diversified.
LEVERAGE is measured by total liabilities divided by shareholder
equity. It indicates what percentage of equity and debt companies
use to finance their assets. A lower level of debt means that a
company is using less of its earnings to pay off interest and as
such has more available to distribute to shareholders and invest
in its operations.
We have found that combining these three metrics may produce
better long-term results and a more diversified portfolio than
relying on a single metric.
quality characteristics that are measured according to
clearly defined fundamental rules. Quality investing was first
The Long-Term Evidence for the Quality Premium
popularized by Benjamin Graham — often remembered as
According to the Efficient Market theory, markets process news
the father of value investing — in the early 1930s. He defined
efficiently, therefore the current market price should already
quality as sustainable earnings power.
reflect the future growth and profitability of a company, especially
Though quality definitions can differ, most are broadly similar,
for those well-established firms which are closely followed by
reflecting investors’ focus on balance sheet quality, earnings
investors and analysts. In consequence, investing in those high
quality/stability and corporate governance. For example, GMO
quality firms should not offer positive excess future returns.
defines quality companies as those with high and stable
However, empirical research shows the opposite: quality stocks
profitability and low debt, while Standard and Poor’s quality
historically outperform the market over long time periods, with
ranking measures long-term growth and stability of earnings
relatively low volatility — delivering a higher efficiency ratio.
and dividends.
To demonstrate the existence of a quality premium, we use
At State Street Global Advisors, we adopt a similar definition. We
a simple methodology to analyse the risk-return profiles of
define quality as high profitability, low earnings variability and
stocks grouped by their quality score. With MSCI World as
low leverage, and believe that these safe, profitable and solid
the universe, we divide the stocks into 20 quality-ranked
businesses will produce superior returns over the long term.
sub-portfolios. (Their annual quality ranking as of March
month-end each year is used).
IQ INSIGHTS | WHY QUALITY INVESTING?
A sub-portfolio with higher quality ranking is assigned a
higher group number, e.g. sub-portfolio 20 has higher quality
score than sub-portfolio 19 and sub-portfolio 1 has the lowest
Figure 3: Quality Tercile Risk and Return Profile
March 1993 to October 2013
quality score. Consequently, each sub-portfolio represents 5%
of the universe market capitalisation and stocks within each
sub-portfolio are capitalisation-weighted.
The following two charts illustrate the sub-portfolios’ historical
returns (annual return and standard deviation) from April 1993
to Oct 2013.
Annual Return (%)
Annual Volatility (%)
Efficiency Ratio
Low
Quality
Middle
Quality
High
Quality
MSCI
World
5.86
18.69
0.31
8.10
14.61
0.55
9.75
13.70
0.71
7.79
15.29
0.51
Source: State Street Global Advisors, October 2013.
The simulated performance shown is not necessarily indicative of future performance, which
could differ substantially. Please see the Appendix for additional disclosure.
Past performance is not a guarantee of future results.
Figure 1: Quality-Sorted Returns
Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Index returns reflect all items of income, gain and loss and the reinvestment of dividends and
other income.
MSCI World Sub-Portfolio Annualised Returns (USD), April 1993 to October 2013
As the charts illustrate, stocks with higher quality tend to deliver
Percent
higher returns and be less volatile than their lower quality
12
counterparts over the period. Lower quality stocks tend to have
10
lower annualized return with higher volatility.
8
If we group the stocks into 3 segments we can more clearly see
6
the performance differences.
4
Segment or Tercile 1 contains stocks of sub-portfolio 1 to 7
2
0
(low quality), Tercile 2 contains stocks of sub-portfolio 8 to 13
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20
Sub-Portfolios (High Quality to Right)
Source: State Street Global Advisors, MSCI, October 2013.
Past performance is not a guarantee of future results.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Index returns reflect all items of income, gain and loss and the reinvestment of dividends and
other income.
The simulated performance shown is not necessarily indicative of future performance, which
could differ substantially. Please see the Appendix for additional disclosure.
(middle quality) and Tercile 3 contains the remaining stocks
(high quality).
The above evidence suggests that high quality stocks can
outperform lower quality stocks, and indeed the market as
a whole.
There are various explanations to the outperformance of higher
quality. One explanation is that companies with more stable
earnings can be expected to have more stable stock prices,
Figure 2: Quality-Sorted Volatility
which suggests that the quality factor may capture some
MSCI World Sub-Portfolio Annualized Return Volatility (USD), April 1993 to
October 2013
benefits that are similar to those of low volatility factors.
Percent
Further, some studies found that investors tend to under-
25
react to corporate quality. High quality stocks are solid
profitable businesses with low risk that investors are willing
20
to pay a high price for, however the quality information
is only slowly incorporated into the price, leading to
15
subsequent outperformance.
10
No matter what the source of the quality premium is, the
5
0
historical, long-term outperformance of high quality stocks over
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20
Sub-Portfolios (High Quality to Right)
low quality stocks is undeniable. However, past performance is
not a guarantee of future results.
Source: State Street Global Advisors, MSCI, October 2013.
Past performance is not a guarantee of future results.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Index returns reflect all items of income, gain and loss and the reinvestment of dividends and
other income.
The simulated performance shown is not necessarily indicative of future performance, which
could differ substantially. Please see the Appendix for additional disclosure.
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IQ INSIGHTS | WHY QUALITY INVESTING?
How to Capture the Quality Premium
Additionally, State Street Global Advisors has developed a
Several investment approaches are possible:
proprietary Quality-Tilted solution that aims to capture the quality
premium in a passive way using a set of pre-defined rules.
a) Directly capture the quality premium by tracking a quality
index or investing in a quality-tilted portfolio;
b) Implement portfolio diversification by combining quality
investing with other factor investing;
c) Use quality as a screen to complement other factors.
•
State Street Global Advisors Quality-Tilted Solution: weights
stocks from the underlying cap-weighted index by leverage
(low debt to equity ratio), profitability (high pre-tax return
on assets) and low earnings volatility (standard deviation
of EPS/median earnings for the past 5 years). Factors are
normalized and averaged to produce the quality score for
a) Direct Investment
each stock. Stocks are first ranked by quality scores, then 20
A number of indexes capture the quality premium. Some of
sub-portfolios of equal market value are formed. Sub-portfolio
these include:
1 has the lowest quality and Sub-portfolio 20 has the highest
quality. The strategy is rebalanced annually.
•
MSCI Quality Index: Selects stocks from the cap-weighted
parent index based on 3 quality factors:
1. Return on Equity (trailing 12-month EPS/latest book
value-per-share),
Figure 4 below shows the correlation of excess returns over a
cap-weighted benchmark of a number of State Street Global
Advisors tilted Solutions (including value, size, quality, volatility
2. Debt-to-Equity (total debt/book value) and
and momentum). The quality-tilted strategy is negatively
3. Earnings Variability (standard deviation of year-over-year
correlated with value and size, since it tends to overweight
EPS growth over the past 5 fiscal years).
A fixed number of stocks with the highest quality scores
based on the average of the Z scores1 of the 3 factors above
are included in the index, which consists of about 30% of
the market cap of the parent index. Each stock’s weight is
calculated by multiplying its quality score by its market cap
weight in the parent index. The weights are then normalized
to sum to 100%. The index is rebalanced semi-annually.
•
b) Solution Diversification
large, profitable companies as opposed to value and size,
which favour small distressed companies. On the other hand,
quality is positively correlated with volatility. Given the
long-term premium and low correlation with other factors, it
would seem sensible to include quality investing into a multifactor portfolio to incorporate more potential return sources and
improve the diversification effect. Doing so can also reduce the
need to time different factors.
Russell Defensive Index: Selects stocks by its stability
probability — which is based on an equal combination of the
quality score and the volatility score. The quality score is itself
Figure 4: State Street Global Advisors Factor-Tilted Strategy
Excess Return (versus MSCI World Index) Correlation
Correlation of Excess Returns
derived by the equal combination of three quality variables:
Return on Assets, Earnings Variability and Leverage, while
the volatility score is an equal combination of 1-year Price
Volatility and 5-year Price Volatility. The first 35% of the
universe capitalization with the highest stability score is
classified as fully defensive, and the next 30% as both
defensive and dynamic. This index is rebalanced annually.
•
S&P 500 High Quality Rankings Index: Screens stocks from
the cap-weighted parent index based on earnings per share
and dividend records for the most recent 10 years. Based
on the combination of adjusted scores for earnings and
Value
Size
Quality
Volatility
Momentum
Value
Size
Quality
Volatility
Momentum
1.00
0.60
(0.38)
0.13
(0.42)
0.60
1.00
(0.36)
(0.01)
(0.22)
(0.38)
(0.36)
1.00
0.53
0.32
0.13
(0.01)
0.53
1.00
0.24
(0.42)
(0.22)
0.32
0.24
1.00
Source: State Street Global Advisors, October 2013.
The correlation coefficient measures the strength and direction of a linear relationship between
two variables. It measures the degree to which the deviations of one variable from its mean are
related to those of a different variable from its respective mean.
The simulated performance shown is not necessarily indicative of future performance, which
could differ substantially. Please see the Appendix for additional disclosure.
dividends, stocks with quality rankings of A- and above
will become index members. The weight for each stock
One sensible and practical approach may be to combine quality
is set proportional to its quality ranking score versus the
with value. Both academia and industry have long noticed the
sum of quality ranking scores of all members. The index is
benefit of combining value investing with quality investing.
rebalanced quarterly.
A simple value strategy does not distinguish between an
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IQ INSIGHTS | WHY QUALITY INVESTING?
The above figure illustrates the 3-year rolling excess return of
Figure 5: 3-Year Rolling Excess Returns of MSCI World
Value-Weighted, Quality-Weighted and Combo Portfolio,
April 1993–April 2013
equally combining the MSCI Value-Weighted Index with the
MSCI Quality-Weighted Index over the past 20 years.
Percent
As we can see, value and quality alone both suffer
20
underperformance, at different times. A simple equal-weighted
15
combination strategy outperforms the cap-weighted benchmark
most of the time in any rolling 3-year period. The combined
10
portfolio captures most of the excess returns from Value and
5
Quality, but with a much lower return volatility than Value,
0
and much lower tracking error than both of the individual
-5
strategies, suggesting a higher information ratio than both
-10
Mar
1996
2000
2004
2009
Aug
2013
the individual strategies and the cap-weighted benchmark.
The relative drawdown is also significantly lower than the
— MSCI World Value Weighted 3-Year
— MSCI World Quality 3-Year
— Combined 3-Year
individual strategies.
Source: State Street Global Advisors, October 2013.
combines Quality with Value and Quality with Volatility, and a
Past performance is not a guarantee of future results.
multi-factor model that combines Quality, Value and Volatility.
State Street Global Advisors also offers a two-factor model that
Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Index returns reflect all items of income, gain and loss and the reinvestment of dividends and
other income.
The simulated performance shown is not necessarily indicative of future performance, which
could differ substantially. Please see the Appendix for additional disclosure.
c) Use Quality as a Screen
Quality factors can be also used as screening for strategies
using other factors (e.g. high dividend or value). Adding a
quality screen overlay on top of the value factor can help
Figure 6: Risk and Return Profile of MSCI Value-Weighted,
Quality-Weighted and Combo Portfolio, April 1993–April 2013
Combined
Annual Return (%)
Annual Volatility (%)
Efficiency Ratio
Excess Return (%)
Tracking Error (%)
Information Ratio
Maximum Relative
Drawdown (%)
MSCI Value MSCI Quality
Weighted
Weighted
MSCI World
9.66
14.62
0.66
2.04
2.77
0.74
-22.80
8.85
15.95
0.55
1.23
3.23
0.38
-42.10
10.71
14.17
0.76
3.09
5.69
0.54
-10.30
7.62
15.30
0.50
-
avoid investing in stocks that are seemingly cheap but that
may actually entail greater risks, thereby mitigating the value
trap risk.
Several index providers have incorporated a quality screen for
their other alternative weighting indices. For example, S&P
employs a strict methodology for its dividend indices. To be
eligible for inclusion in the US index, companies must have
grown their dividends every year for at least 20 years, while
eligibility for the eurozone and UK indices rests on having stable
or growing dividends for at least 10 years. As a result of these
requirements, many of the companies that make up these
Source: State Street Global Advisors, October 2013.
indices also have high quality characteristics, such as relatively
Past performance is not a guarantee of future results.
low variability in earnings.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Index returns reflect all items of income, gain and loss and the reinvestment of dividends and
other income.
To better illustrate this point, we have compared the
The simulated performance shown is not necessarily indicative of future performance, which
could differ substantially. Please see the Appendix for additional disclosure.
performance of two groups of stocks that are both attractively
valued but while one group of stocks has the top quintile quality
scores, the other scores very low on quality. Between April
expensive stock that is high quality (profitable), and one that is
1993 and October 2013, the best value-best quality stocks
low quality (unprofitable). As Warren Buffet once said ‘It’s far
outperformed the best value-worst quality stocks by 27.70%,
better to buy a wonderful business at a fair price than to buy a
and also outperformed the MSCI World Index itself by 7.14%.
fair business at a wonderful price.’ Combining value with quality
can help identify good quality businesses at fair prices and/or
cheap stocks with good quality.
Put into a broader portfolio universe, if we remove the
worst quartile quality stocks from a value-tilted portfolio,
the simulated, cumulative return improved by 113%. The
simulated, annual volatility was also reduced from the original
16.08% to 14.13%.
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IQ INSIGHTS | WHY QUALITY INVESTING?
Many Ways to Capture the Quality Premium
Figure 7: Cumulative Return of a Value-Tilted Portfolio
without the Bottom Quartile Quality Stocks versus Standard
Value-Tilted Portfolio
There are various options available for investors to potentially
capture the quality premium in a passive, transparent and low
cost way, such as potentially capture or investing in State Street
8
Global Advisors’s own Quality-Tilted approach. In addition,
investors can combine quality with other factors to attempt to
6
improve portfolio factor diversification and to mitigate interim
volatilities that arise from investing in single-factor portfolios.
4
Investors can also use quality as a screening overlay on top of
the single factor model such as value, volatility, dividend yield
2
etc. to meet different needs and achieve different objectives. As
0
Apr
1993
1998
2003
2008
Oct
2013
— Value Tilt_x Bottom Quality
— MSCIWorld
— Value Tilt_Standard
Source: State Street Global Advisors, October 2013.
such, investors may want to consider adopting quality investing
into their equity investment spectrum.
1
The z-score is the number of standard deviations an obervation is above the mean. A positive
z-score represents a datum above the mean, while a negative z-score represents a datum
below the mean.
Past performance is not a guarantee of future results.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Index returns reflect all items of income, gain and loss and the reinvestment of dividends and
other income.
The simulated performance shown is not necessarily indicative of future performance, which
could differ substantially. Please see the Appendix for additional disclosure.
5
IQ INSIGHTS | WHY QUALITY INVESTING?
State Street Global Advisors Worldwide Entities
Australia: State Street Global Advisors, Australia, Limited (ABN 42 003 914 225) is the holder of an Australian Financial Services Licence (AFSL Number 238276). Registered Office: Level 17, 420
George Street, Sydney, NSW 2000, Australia • Telephone: +612 9240-7600 • Facsimile: +612 9240-7611. Belgium: State Street Global Advisors Belgium, Office Park Nysdam, 92 Avenue Reine
Astrid, B-1310 La Hulpe, Belgium • Telephone: +32 2 663 2036 • Facsimile: +32 2 672 2077. State Street Global Advisors Belgium is a branch office of State Street Global Advisors Limited. State
Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Canada: State Street Global Advisors, Ltd., 770 Sherbrooke Street West, Suite
1200 Montreal, Quebec, H3A 1G1, 514-282-2400 and 30 Adelaide Street East Suite 500, Toronto, Ontario M5C 3G6 • Telephone: 647-775-5900. Dubai: State Street Bank and Trust Company
(Representative Office), Boulevard Plaza 1, 17th Floor, Office 1703 Near Dubai Mall & Burj Khalifa, P.O Box 26838, Dubai, United Arab Emirates • Telephone: +971 (0)4-4372800 • Facsimile:
+971 (0)4-4372818. France: State Street Global Advisors France. Authorised and regulated by the Autorité des Marchés Financiers. Registered with the Register of Commerce and Companies of
Nanterre under the number: 412 052 680. Registered Office: Immeuble Défense Plaza, 23-25 rue Delarivière-Lefoullon, 92064 Paris La Défense Cedex, France • Telephone: (+33) 1 44 45 40 00 •
Facsimile: (+33) 1 44 45 41 92. Germany: State Street Global Advisors GmbH, Brienner Strasse 59, D-80333 Munich • Telephone: +49 (0)89-55878-100 • Facsimile: +49 (0)89-55878-440. Hong
Kong: State Street Global Advisors Asia Limited, 68/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong • Telephone: +852 2103-0288 • Facsimile: +852 2103-0200. Ireland:
State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered Number:
145221. Member of the Irish Association of Investment Managers • Telephone: +353 (0)1 776 3000 • Facsimile: +353 (0)1 776 3300. Italy: State Street Global Advisors Italy, Sede Secondaria di
Milano, Via dei Bossi, 4 20121 Milan, Italy • Telephone: +39 02 32066 100 • Facsimile: +39 02 32066 155. State Street Global Advisors Italy is a branch office of State Street Global Advisors Limited.
State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Japan: State Street Global Advisors (Japan) Co., Ltd., 9-7-1 Akasaka,
Minato-ku, Tokyo 107-6239 • Telephone: +813 4530 7380. Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #345). Japan Investment Advisers Association, Investment
Trusts Association Japan, Japan Securities Dealers Association. Netherlands: State Street Global Advisors Netherlands, Adam Smith Building, Thomas Malthusstraat 1-3, 1066 JR Amsterdam,
Netherlands • Telephone: +31 (0)20 7181701. State Street Global Advisors Netherlands is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised
and regulated by the Financial Conduct Authority in the United Kingdom. Singapore: State Street Global Advisors Singapore Limited, 168, Robinson Road, #33-01 Capital Tower, Singapore 068912
(Company Registered Number: 200002719D) • Telephone: +65 6826-7500 • Facsimile: +65 6826-7501. Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Zurich • Telephone:
+41 (0)44 245 70 00 • Facsimile: +41 (0)44 245 70 16. United Kingdom: State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England.
Registered Number: 2509928. VAT Number: 5776591 81. Registered Office: 20 Churchill Place, Canary Wharf, London, E14 5HJ • Telephone: +020 3395 6000 • Facsimile: +020 3395 6350. United
States: State Street Global Advisors, One Lincoln Street, Boston, MA 02111-2900 • Telephone: (617) 664-7727.
Web: ssga.com
The views expressed in this material are the views of Taie Wang and Bruce Zhang through the period ended April 2014 and are subject to change based on market and other conditions. This
document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or
developments may differ materially from those projected. Past performance is not a guarantee of future results.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness
of, nor liability for, decisions based on such information and it should not be relied on as such.
For use with SSgA clients only. The Advanced Beta solution is a concept for discussion purposes only. The information provided herein does not constitute investment advice and is not a solicitation. It
does not take into account any investor’s particular investment objectives, risk tolerance, or financial and tax status.
Diversification does not ensure a profit or guarantee against loss.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles
or from economic or political instability in other nations.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less
diverse and mature and to political systems which have less stability than those of more developed countries.
Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market
capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.
Investments in small/mid-sized companies may involve greater risks than in those of larger, better known companies.
Investing involves risk including the risk of loss of principal.
Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
Standard & Poor’s (S&P) S&P Indices are a registered trademark of Standard & Poor’s Financial Services LLC.
The simulated performance shown was created by the Index Equity Group. Backtesting was used to calculate simulated performance. The results shown do not represent the results of actual trading
using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight. The simulated performance was compiled after the end of the
period depicted and does not represent the actual investment decisions of the advisor. These results do not reflect the effect of material economic and market factors on decision-making.
The simulated performance data is reported on a gross of fees basis, but net of administrative costs. Additional fees, such as the advisory fee, would reduce the return. For example, if an annualized
gross return of 10% was achieved over a 5-year period and a management fee of 1% per year was charged and deducted annually, then the resulting return would be reduced from 61% to 54%. The
performance includes the reinvestment of dividends and other corporate earnings and is calculated in US dollars.
The simulated performance shown is not necessarily indicative of future performance, which could differ substantially.
© 2014 State Street Corporation. All Rights Reserved.
ID0927-INST-4562 0314 Exp. Date: 31/05/2015
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