One of the largest recipients of investor inflows in 2022 was the VanEck Vectors MSCI World Ex-Australia Quality ETF (ASX: QUAL). The ETF captured the fourth largest share of new investor money with $671 million in inflows over the course of the year.

In a year where the market punished the unprofitable darlings of the post-COVID surge investors were clearly searching for a port in the storm.

Quality investing can take on several forms but at a high level it involves finding businesses that are financially stable and consistently profitable while displaying limited earnings volatility.

The popularity of a recent Investing Compass episode exploring quality ETFs demonstrated the renewed interest in the investment approach.



Does investing in quality lead to outperformance?

Underpinning the growth in popularity of a quality investment approach is numerous pieces of academic research. 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.

An investment strategy based on quality is a type of factor investing.

Factor investing involves the identification of attributes that have historically led to outperformance.

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.

Why the renewed interest in quality?

There is no single way to explain the actions of millions of investors that are making decisions based on their own personal circumstances. However, we do see a flight to quality across all asset classes during times of economic upheaval and distress.

2022 certainly fit the bill with multi-decade highs in inflation, one of the fastest interest rate tightening cycles in history and the looming threat of recession hanging over global markets.

This thesis of quality outperforming the overall market during times of distress did not play out in 2022.

The QUAL ETF trailed the overall global index as represented by the Vanguard MSCI International ETF (ASX: VGS) by close to 4% with a 17.92% loss in 2022. Yet no investment strategy should be evaluated over the short-term.

A quality investing approach is no different.

Over the past 5 years QUAL outperformed with a total return of 11.50% per annum vs. 9.23% for VGS. If we go back to 1999 the MSCI World Quality Index which QUAL tracks has outperformed by 1.98% per annum over the overall MSCI World Index.

The main culprit during 2022 for QUAL was overweight positions in the US and the technology sector. Both poor performers last year.

QUAL allocates over 76.4% of the overall portfolio to the US and north of 29% to the technology sector. This compares to a 69% allocation to the US for VGS and a 19% position in the technology sector.

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.

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.

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

As demonstrated in 2022 certain portfolio tilts can have an impact on short and long-term returns. Another area to examine is rebalancing as that may have tax consequences related to distributed capital gains.

Two ETF opportunities for investors interested in quality

Let's take a look at what Morningstar analysts think of these two ETFs.

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%.

Our analysts have conviction that the strategy can deliver outperformance over its’ ability to outperform peers over the long-term.

Our analyst summarises QUAL as follows, “We believe that for investors seeking to diversify their core Australian equity exposure, QUAL presents a strong choice for its solid investment thesis, effective implementation, and unmatched performance offered at a competitive price.”

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.

We note that the ETF portfolio construction methodology stems from rigorous academic research that underpins the hypothesis of long-term outperformance based on the inclusion of quality, value and low volatility factors. The fee is reasonable at .40%.

In summary, our analysts describes the ETF as follows, “QMIX offers a cost-effective proven multifactor approach, good diversification, and a track record of effective implementation, which should reward long-term investors.”