Insight

In Troubling Times, Shine the Spotlight on Quality ETFs

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Even the savviest and most seasoned investor has never seen market behavior like that of the past six weeks. The dramatic down and up moves across virtually all asset classes leave us wondering if any investment has a future. We believe the sun will eventually shine again and suggest during periods of economic turbulence and credit stress that investors may wish to consider companies demonstrating financial strength. These quality businesses generally feature low leverage and strong cash flow and may provide the opportunity for desirable long-term returns.  

What is a “quality” company?
For those of us at Invesco involved in ETF strategy, a quality company is one with strong cash flow and a healthy balance sheet. By this definition, quality is more concerned with a company’s financial position rather than earnings growth or valuation. One of the explanations for how the quality factor potentially rewards investors is this focus on financial health. Of course, these metrics (return on equity, cash flow generation and leverage) take time to analyze but can also provide general economic and industry insight, which can be of great value to investors. 

The quality continuum
In order to better understand the characteristics of quality, it may be instructive to compare a generally accepted “quality” index to one that is of lesser quality. We will use the S&P 500 High Quality Index and S&P 500 High Beta Index (the lower quality proxy) as examples. High beta stocks tend to be more cyclical, use higher leverage, have weaker balance sheets, and generate lower profitability. The table below highlights that the S&P 500 Quality Index has less debt, a higher return on equity, stronger cash flow and more robust profit margins than the S&P 500 High Beta and the S&P 500. 

Select financial ratios for the S&P 500 Quality, the S&P 500 High Beta, and the S&P 500 Indexes

Index Debt to Equity Return on Equity Cash Flow Operations/Debt

Profit Margin
S&P 500 High Quality
70.6% 25.2% 1.11 14.6%
S&P 500 High Beta 104.0% 5.2% 1.01 3.6%
S&P 500 121.8% 15.1% 0.83 10.1%

Source: Bloomberg L.P. as of March 31, 2020. Investors cannot invest in an index. Past performance is not a guarantee of future results. Index returns do not represent fund returns.

In our experience, we believe that the S&P 500 High Beta Index is more cyclical than the S&P 500 Quality Index, due in part to overweights in the financial, energy, and technology sectors. These are very cyclical sectors due to dependence on interest rates, oil/gas prices and manufacturing. In the technology sector, semiconductor companies are also subject to their own investment cycle.

How has the quality factor performed in a stressed market?
Quality has tended to demonstrate outperformance against high beta during periods of rising risk, as seen by an increase in the CBOE Volatility Index (VIX) or widening of high-yield spreads3. In contrast, quality has lagged high beta during periods of falling risk when the VIX and high-yield spreads are declining.   As a result, quality has been more defensive than high beta or stocks with lower quality. 

Quality has also tended to outperform against the S&P 500 when the VIX is rising and high yield spreads are widening; and it underperforms the S&P 500 when the VIX is falling and high-yield spreads are narrowing.

Comparison of weekly average returns of the S&P 500 Quality Index, the S&P 500 High Beta Index, and the S&P 500 Index by Weekly S&P 500 Index Return

S&P 500 S&P 500 Quality Index S&P 500 High Beta Index -
S&P 500 Quality Index
S&P 500 Index S&P 500 Quality Index -
S&P 500 Index
< -1.50% -3.909% -5.517% 1.608% 0.093%
0% to -1.50% -0.662% -1.223% 0.561% 0.020%
-1.50% to 0% 0.619% 0.751% -0.132% -0.042%
> 1.50% 2.517% 3.376% -0.859% -0.009%

Source: Bloomberg L.P. as of March 31, 2020.  Investors cannot invest in an index. Past performance is not a guarantee of future results. Weekly average returns shown are for each week beginning July 1, 2014 through March 27, 2020, broken into the S&P 500 Index return buckets shown in the left column.  

Looking at movements in the S&P 500 Index, the S&P 500 Quality Index has shown relative strength to the S&P 500 High Beta Index when the S&P 500 Index is falling; it underperforms when the S&P 500 Index is rising. This highlights the more defensive characteristics of quality relative to low quality or high beta. The S&P 500 Quality Index has tended to show outperformance against the S&P 500 Index when the S&P 500 is declining; it lags slightly when the S&P 500 is rising. This indicates that quality can have defensive characteristics, but allows investors to participate in periods of economic strength

Quality may equal opportunity
Investors interested in quality investing may want to explore Invesco quality ETF options. Invesco S&P 500 Quality ETF (SPHQ), Invesco S&P MidCap Quality ETF (XMHQ), and Invesco S&P SmallCap Quality ETF (XSHQ) all provide access to the quality factor in their respective market cap spectrums. The recent shock to economic growth caused by the COVID-19 pandemic, coupled with the crash in energy prices, has the potential to brighten demand for companies with strong balance sheet and cash flow characteristics.

Footnotes

  • 1

    S&P as of February 29, 2020

  • 2

    Bloomberg L.P. as of March 31, 2020

  • 3

    As defined by the BarCap US Corporate High Yield Yield to Worst – 10 Year Spread Index as of March 31, 2020.