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3 Index Investing Strategies That Prioritize Quality Results

02/14/2019

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Index investing strategies have become exceptionally popular in recent decades, but innovators and academics are delving increasingly into strategies designed to improve upon the benefits provided by simple indexes.
If you are indexing, you cannot produce alpha, which is fine for many people. However, there is value in outperformance, so passive investment providers have devoted resources to new tools which can produce returns that exceed the market in general.

Quality Index Funds, and How You Can Use Them

Indexes have been developed for which membership is based on quality metrics rather than simple market capitalization. Any funds that track these indexes will naturally provide more exposure to quality than simple market-capitalization weighting.

Several index creators, such as MSCI and S&P have developed quality indexes that have portfolio composition based on three quality factors:

  • Return on equity
  • Debt-to-equity ratio
  • Earnings volatility

Several ETFs and mutual funds from institutions such as iShares and Fidelity are designed to track these quality portions of popular parent indexes.

Quality scores are associated with each factor, and a composite score is assigned to each stock within a target parent index, so that only a certain number of securities are admitted to the quality index. The goal is to eliminate any stocks that fail to adhere to specific risk and stability standards, thus improving outcomes for index investors.

Return on equity (ROE) is a financial metric devised to measure a company’s ability to generate profits relative to net shareholder equity, and high ROE typically indicates a more efficient enterprise. ROE analysis is often broken into three separate statistics, net margin, asset turnover and equity multiplier, which are multiplied together to calculate ROE. These statistics measure profitability, the sales being generated by assets, and financial leverage, respectively, and all are important considerations for fundamental analysis.

Total market ROE is estimated around 13%, and industries that tend to deliver above-average ROE include consumer basics, transportation, and healthcare facilities.

Stable earnings are considered favorable for quality indexes, so highly cyclical stocks can be excluded through measurement of earnings volatility. Basic consumer goods, healthcare, food, and beverages are all considered less cyclical, and these are likely to deliver stable profit margins. This factor should also weed out less-stable companies with over-exposure to specific customers, geographical markets, or individual products and services.

The debt-to-equity ratio is calculated by dividing total liabilities by net shareholder value, and it is deployed to analyze capital structure. Exceptionally high debt-to-equity can represent higher risk to equity holders, all other factors being equal, so the quality rating seeks to eliminate over-leveraged companies.

Total market debt-to-equity, excluding the impact of financial sector companies which are structured in fundamentally unique ways, is around 0.30, with technology, pharmaceutical, beverages, and tobacco delivering some of the lowest leverage firms.

Tracking quality indexes is a strategy with inherent flaws, so investors should understand the strengths and weaknesses to optimize results. Quality factors will disproportionately select stable, mature, and non-cyclical companies – but the methodology is biased against certain classes that are otherwise considered beneficial across the various phases of the market cycle.

Financials, telecom, real estate and energy production and distribution, which are an important parts of the modern economy, are threatened by omission from quality indexes due to capital structure, while defensive industries like health care facilities and grocery stores are also penalized for high leverage, despite being common safe landing spots during market turmoil.

During bull markets, cyclical companies and promising growth stocks (for example the famous FANG group before their rise to prominence) can be among the best-returning positions in the market. In an effort to eliminate downside risk, quality index methodology would likely avoid these opportunities, and that carries an undeniable opportunity cost.

There is little doubt that quality indexes can be a fantastic vehicle for passive investors hoping to dampen portfolio volatility, but it is unlikely to appeal to investors who embrace volatility to maximize upside exposure.

Quality Indexing – Having Your Cake and Eating it Too

Investors can also selectively embrace simple market-cap-weighted indexes, by seeking exposure to specific quality factors that vary among the indexes. This is a more do-it-yourself approach that compartmentalizes various quality factors, but can be a more tailored approach to gain some of the alpha developed by the quality index methodology.

If cyclicality and volatility are problematic, investors can purchase funds that track sector indexes such as consumer defensive, health care and utilities. These companies are unlikely to deliver substantial growth relative to other large-cap peers, but they should be downside protection for bear markets. This approach would minimize the impacts of highly cyclical sectors and high-flying growth stocks from sectors such as technology, which will typically plunge furthest during market corrections.

If investors believe that highly leveraged capital structures carry unacceptable risks, investors can similarly select sector and industry-specific indexes where capital structure tends to be lean, such as technology, the NASDAQ 100, or beverages.

For the purposes of downside protection, investors should generally embrace a broad base of larger, more mature companies that have diversified business operations and pay dividends that will generate returns even as portfolio value plunges. This would indicate preference for funds tracking the S&P 500, the Dow Jones Industrial Index, the Dow Jones Global Titans 50 or MSCI World Index, while avoiding the likes of the Russell 2000 or Emerging Markets.

The Rise of Factor Investing

Academics such as Eugene Fama and Kenneth French dedicated extensive time and resources to studying the various characteristics of portfolios that delivered strong performance over time, and their work has been very influential in the analysis of active management performance and portfolio composition theory.

This research gave rise to factor investing and smart beta, which seek to construct rules-based portfolios providing exposure to stock characteristics that deliver superior performance to simple value weighting, but are otherwise passively managed.

Fama and French influentially identified market capitalization, price-to-book valuation and profitability as strong factors for determining portfolio performance, and they helped implement this methodology through a fund manager called Dimensional Fund Advisors. DFA builds diversified portfolios that are disproportionately exposed to smaller, cheaply valued and profitable companies, which tend to outperform other names on the market, and DFA has historically delivered strong results relative to benchmarks.

This success has been replicated and expanded by portfolio managers and financial institutions across the world, and with dozens of other significant factors being identified and embraced, and the proliferation of smart beta funds. Investors seeking quality results can turn to these ETFs and mutual funds in this category, though the results are often designed to be quite different from the above quality indexing strategies.

Linden Thomas & Company

One of America’s Top Wealth Managers builds a better Index

At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

We agree with many long-term academic studies that continue to validate the importance of how quality earnings are directly connected to real equity performance…

Do I Qualify Read More chevron_right
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