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With the value rally aging, which by the way isn't a bad thing, some attention is shifting to what comes next in Factor Land. No, that doesn't mean it's all about growth stocks although that group is recently showing some strength.
There's a rising chorus of market observers pointing to quality, a factor that's been overlooked for much of this year due to the junky flavor of the value rally. Depending on the benchmark an advisor observes, quality is actually doing pretty well this year. For example, the MSCI USA Sector Neutral Quality Index is up 16% year-to-date, matching the S&P 500.
The renewed interest in quality isn't surprising. As was recently discussed here, it's not unusual for value rebounds, such as the one currently at play, to be ignited by lower quality stocks. History also indicates that as a value rally gains steam, it's common that market participants eager to stay with value will rotate out of low-quality equities into higher quality ideas.
In other words, as was the case with value 10 months ago, quality's resurgence today is in its early innings, indicating there's plenty more where recent strength came from.
Quality Endorsement
Due to the fluidity of what defines the quality factor – a trait not often shared by other factors – stock picking in the essence of quality can be tricky. To that end, exchange traded funds are effective tools for advisors to deploy in an effort to focus on this factor.
“We have a Favorable rating on US Quality ETFs today because we expect the category to outperform over the remainder of this business cycle. Our US equity strategists recently emphasized the bull case for high-quality stocks, citing four key reasons to allocate,” according to a recent research note from Bank of America.
The quartet of reasons the bank cites as catalysts for quality ETFs are valuations, tapering of the Federal Reserve's asset buying program, macro hedges and quality's positioning as a factor that offers more growth prospects than many clients realize.
Indeed, now is a great time for advisors to have client conversations regarding quality because, as Bank of America points out, high-quality equities currently traded at decade-low price-to-earnings multiples, these stocks have penchants for outperforming as the Fed dials back bond buying and earnings growth slows, investors typically display a willingness to pay up for quality.
Among quality ETFs, the bank favors the iShares MSCI USA Quality Factor ETF (CBOE:QUAL) and the Invesco S&P 500 Quality ETF (NYSEARCA:SPHQ). QUAL tracks the aforementioned MSCI USA Sector Neutral Quality Index while SPHQ follows the S&P 500 Quality Index.
Encouraging Signs for Both ETFs
Based on pure performance, SPHQ is the winner of the pair this year, up 16.72%, beating its iShares rival by a modest margin. Good news: Things are looking up for both quality ETFs.
“We expect each of these conditions to occur over the next 6-12 months. The early-cycle valuation gap is likely to close, the Fed may begin tapering asset purchases; corporate profits will likely peak, and peaking PMIs and higher volatility will push investors toward higher-quality stocks,” according to Bank of America.
Check out the chart below for illustrations of quality's upside potential:
Courtesy: Bank of America Global Research
The overlap by weight between the two funds is 37%, confirming they share many of the same holdings, but these ETFs aren't twins. For example, QUAL features more communication services and consumer discretionary exposure than its rival while the Invesco fund is overweight tech and financial services stocks.
Either way, there's a lot to like with both funds making these ideas potentially compelling to clients.
“QUAL remains our top pick, with low expenses, ample liquidity, and the strongest price momentum. We upgrade SPHQ to Buy because of its strong fundamental profile, with the highest share of quality stocks relative to Underperform-rated stocks and underweighted sectors,” notes Bank of America.
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