Factor investing involves the identification of certain characteristics in shares that have historically led to positive outcomes for investors. Once the desired characteristic is picked shares are screened to find individual companies that have those attributes.

Popular factors include quality, momentum, value and size. Investors can buy individual shares that meet these characteristics or rely on an ETF or fund that follows a particular strategy.

Why quality?

There are numerous pieces of academic research that show the quality factor is attractive. Much of this research is fairly recent but is underpinned by Warren Buffett’s goal of identifying great companies that could be held over the long-term.

Factor investing and the inclusion of quality as a factor began with academic research by Nobel laureates Eugene Fama and Kenneth French who expanded their famous three factor model in 2014 to include quality in their list of factors that contribute to long-term outperformance.

For more on the quality factor listen to our podcast episode.

What denotes quality?

There is no single definition of what constitutes a quality company and each ETF following that strategy takes a slightly nuanced approach.

Vaneck MSCI International Quality (ASX: QUAL) uses a screen that identifies high-quality shares based on attractive returns on equity, stable earnings growth and low financial gearing.

A competitor product the SPDR MSCI World Quality Mix ETF (ASX: QMIX) combines quality, value and low volatility measures to select holdings. Quality measures include return on equity, debt/equity ratios and earnings variability.

Value is denoted by low price / earnings, price / book and enterprise value / cash flow ratios. Low volatility screens capture shares that bounce around less than the overall market.

VanEck Morningstar Wide Moat ETF (ASX: MOAT) uses Morningstar’s Moat Ratings as a proxy for quality. Our analysts assess each company in their coverage universe on their ability to sustain a competitive advantage over the long-term.

A company that we believe will sustain a competitive advantage for 10 or more years receives a Narrow Moat Rating while those we believe will maintain the advantage for 20 or more years receives a Wide Moat Rating. This is part of our attempt to identify great businesses and there is evidence it leads to outperformance over the long-term.

The different approaches to identifying quality companies should be examined by investors to determine the impact on the holding of the ETF.

Vaneck MSCI International Quality ETF (ASX: QUAL)

This ETF receives a Silver rating from our analysts and our latest research report notes that QUAL is a strong choice for investors seeking exposure to high-quality global equities at a low fee of .40%.

In seeking high-quality global equities at a low cost, the VanEck MSCI International Quality strategy (including the hedged version (ASX: QHAL) stands out.

The strategy fully replicates the portfolio of the MSCI World ex Australia Quality Index. Stocks with quality traits are expected to be more resilient during distressed market and high-volatility conditions, leading to outperformance.

For instance, when the broader market declined by 8%, and an average manager in its category lost 13% (during February-March 2020), this strategy lost just 2.5%. However, in 2022, the same resiliency was not observed, as IT stocks declined notably.

The portfolio identifies high-quality stocks based on attractive return on equity, stable earnings growth, and low financial leverage. This approach yields a portfolio that has notable differences from the MSCI World ex Australia Index in two broad areas: a tilt toward more large-cap growth names and skewness in sectors and geographic exposure. Technology and healthcare are overweightings, while financials are underweightings, as their leveraged balance sheets often do not fit the quality parameter of the strategy.

We view this composition as sensible for diversification of an Australian investor’s equity exposure, where domestically the market is dominated by financials and materials. The dominance of tech and healthcare names has led to ballooning U.S. exposure (77% as of Oct. 31, 2023). However, we do not view this as a specific risk, given the underlying holdings are generally mega-cap multinationals, generating a substantial part of their revenues outside the United States.

Performance-wise, the unhedged class QUAL has had a strong track record since inception. It has outperformed the category index and category average by 2.8% and 4.6% annually since inception (October 2014) through October 2023. The currency-hedging feature of the strategy has weighed on the performance of the hedged class since inception relative to the unhedged class; still, QHAL has outperformed its average peer and category benchmark from its inception (March 2019) through October 2023.

Quality has performed well over multiple periods; however, investors should be careful not to extrapolate past returns. At a 0.40%/0.43% per year management fee, QUAL/QHAL are substantially cheaper than the average active strategy, and VanEck tightly controls its bid-ask spread, making the ETF's overall holding cost appealing.

In summary, QUAL and QHAL are attractive options for investors aiming to diversify their core Australian equity holdings. Their robust investment rationale, efficient execution, and strong track record to date, coupled with a low price, make them very appealing choices.

SPDR MSCI World Quality Mix ETF (ASX: QMIX)

This ETF also receives a Silver rating from our analysts and holds our conviction as a preferred strategy within the large-cap global equity segment.

Within the universe of global large-cap equity strategies, SPDR MSCI World Quality Mix ETF QMIX continues to be a standout choice owing to its uncomplicated methodology that constructs a diversified portfolio tailored with specific factor tilts.

The portfolio construction methodology stems from rigorous academic research that underpins the hypothesis of long-term outperformance correlated with certain factors. The methodology aims to combine the three factors—quality, value, and low volatility—to drive returns in a multifactor framework.

The tracking index is composed of three separate sleeves, each focusing on one of the factors. Research has also shown that certain factors, value and quality in this particular case, are inherently at odds with one another. This results in diversification benefits and also reduces the volatility of the portfolio. On the flip side, the approach also leads to a dilution of individual factor exposure. Further, the inclusion of the low-volatility factor has assisted the fund in generating marketlike returns with appreciably lower risk. Specifically, QMIX did well in protecting capital better than peers when the market slid, such as in the choppy global market of 2018 and through the 2022 correction.

Investors should also note that, owing to the factor exposures, the indexes do not fully capture sharp rallies such as the one witnessed after the global pandemic-driven selloff in 2020.

The significant reduction in the annual fee from 0.40% to 0.18% recently has made the exchange-trade fund even more appealing in terms of total cost, making it the cheapest strategic beta ETFs available in Australia.

The fund derives strong support from the global reach and execution capabilities of its parent State Street. State Street's global equity beta solutions team, helmed by John Tucker, oversees ETF management. The team operates with a clearly defined structure. The research and trading functions are centralized, while portfolio managers operate locally (Alexander King for Australia).

The cohesion between teams, coupled with SSGA's global reach, aids in maintaining minimal trading costs and tracking error for Australia-domiciled passive products.
QMIX stands tall as a cost-effective multifactor strategy, presenting robust diversification with a history of skillful execution, which is likely to reap rewards for committed long-term investors.

VanEck Morningstar Wide Moat ETF (ASX: MOAT)

Increased confidence in VanEck Morningstar Wide Moat ETF's prospects relative to its Morningstar Category peers leads to an upgrade in this strategy's Morningstar Medalist Rating to Gold from Bronze. While the ETF is issued by VanEck Morningstar receives a fee as the ETF tracks a Morningstar index.

The ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Morningstar Wide Moat Focus Index. The Index is intended to track the overall performance of attractively priced US listed companies with sustainable competitive advantages according to Morningstar's equity research team.

The Morningstar Wide Moat Focus Index is a rules based index comprised of at least 40 attractively priced US wide-moats stocks, as determined by Morningstar's time-tested proprietary research. According to Morningstar, wide-moat stocks are companies identified as having sustainable competitive advantages.

Fees are a weakness here at .49%. The strategy's lofty fees are a high hurdle to clear, as it is priced within the second-costliest quintile among peers.