Though high-quality stocks are a good bet to outperform low-quality stocks over the long term, I doubt investors’ need yet another ETF focused on high-quality stocks.
I say this because Jeremy Grantham’s GMO, the Boston-based investment firm, recently announced the launch of a new ETF to invest in high quality stocks. They join the 36 other ETFs that VettaFi’s ETF database lists in its quality stock category, which collectively have around $56 billion in assets under management.
It’s not that GMO doesn’t deserve a piece of that sizable pie. The firm has long extolled the virtues of high-quality stocks, well before many of the Johnny-come-lately ETFs in this category were created. But the firm has long shunned the ETF arena, instead catering to institutions and high-net-worth investors. As a late entrant to a retail arena that is already well saturated, the firm will have a difficult time differentiating its new ETF from the many that already exist.
Though different advisers employ slightly different definitions of quality, there is general agreement that quality stocks are those that are highly profitable and have consistent earnings and healthy balance sheets. So-called “junk” stocks are at the opposite end of the quality spectrum.
One of the more comprehensive studies of quality and junk appeared in the Review of Accounting Studies in 2019. It’s titled “Quality Minus Junk,” the study was conducted by Cliff Asness, Andrea Frazzini, and Lasse Pedersen, all of AQR Capital Management. Frazzini also is an adjunct finance professor at New York University, and Pedersen has academic appointments both at NYU and the Copenhagen Business School.
The researchers defined quality stocks to be those of “profitable, stable, safe” companies that pay out a large percentage of their profits as dividends. To illustrate the investment potential of quality stocks over junk, they calculated the returns of two portfolios: The first contained the 10% of U.S. publicly traded stocks that scored highest according to their criteria of quality; the second portfolio contained the 10% that scored lowest. The portfolios were rebalanced monthly, and transaction fees were not debited.
From mid-1957 through mid-2023—a 66-year period—AQR’s quality stock portfolio outperformed its junk stock portfolio by more than eight annualized percentage points: 11.9% to 3.7%.
The quality-stock funds that currently exist are highly correlated with this hypothetical AQR portfolio. Consider the open-end mutual fund maintained by GMO that focuses on quality stocks, which presumably holds many (if not most) of the same stocks that will eventually be owned by its newly-launched ETF. This open-end fund is the GMO Quality Fund Class III GQETX, which has an initial investment minimum of $5 million. The correlation coefficient between its monthly returns since 2004 and the AQR quality portfolio is an extremely high 0.95.
The same is true for the two largest U.S.-equity ETFs in VettaFi’s quality stock category: The iShares MSCI USA Quality Factor ETF
QUAL,
with $31 billion in assets under management, and the Invesco S&P 500 Quality ETF
SPHQ,
with $6 billion in AUM. The correlation coefficient between the AQR quality portfolio and QUAL is 0.97; with SPHQ it is 0.90.
These very close correlations are plotted in the accompanying chart. It illustrates the marketing challenge GMO faces getting traction with its new ETF.
But that’s GMO’s problem, not ours. The good news for us is that there several ETFs that all do a similar job of capturing the performance of quality stocks. Once you decide to invest a portion of your equity portfolio in quality stocks, there does not appear to be a lot riding on which fund/ETF you pick.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].
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