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Smart Beta Investing: Making a Call on Quality

This article was originally published on ETFTrends.com.

Amid elevated equity market volatility, some investors are tapping factor-based strategies, including the quality factor.

Valuing high quality value is particularly important as bull markets enter their waning stages, as some market observers believe the current bull market is doing. In the early stages of bull markets, lower quality companies see their shares soar. However, as the bull matures, investors often exhibit a preference for higher quality fare with more compelling valuations.

While the S&P 500's October swoon sent some investors to the value factor in a bid to find some compelling deals, quality could ultimately prove to be the way to go.

“Shares of quality companies have been outperforming the broad benchmarks — both before the October market correction and on the bounce of the past two weeks,” reports CNBC.

The Invesco S&P 500 Quality ETF (SPHQ) is one of the elder statesmen of the quality ETF category, having come to market in late 2005. The ETF’s quality tilt comes by way of emphasizing companies’ long-term earnings growth dividend-paying potential. The underlying index focuses on companies with the highest quality as determined by fundamental measures, including return on equity, accruals ratio and financial leverage ratio.

Other Ideas for Quality Investing

There are varying definitions of quality, “but the common traits are a sturdy business not reliant on a strong economy; high and resilient profitability; and a strong balance sheet unburdened by much debt,” according to CNBC.

Many stocks with the quality designation are also steady dividend growers and many of the stocks with the quality designation also have tidy sums of cash on hand.

The Oppenheimer Russell 1000 Quality Factor ETF (OQAL) bets on higher quality companies in the hopes that they perform better than lower-quality companies. The fund screens for an equally-weighted composite of return on assets, change in asset turnover, accruals, and leverage.

Related: The King Among Equal-Weight ETFs

While the quality factor often trades at a premium to value, quality stocks are usually less volatile than traditional broad market strategies.

“Quality has a lot more overlap with defensive stocks. Health care is the best-performing sector in the S&P 500 this year, up more than 12 percent and is among the groups most heavily weighted in quality companies,” according to CNBC.

OQAL allocates a combined 43% of its weight to technology and healthcare stocks compared with 33% in the Russell 1000 Index.

For more information on the smart beta strategy, visit our smart beta category.