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A Solid Avenue For Accessing The Quality Factor

This article was originally published on ETFTrends.com.

The quality factor often goes overlooked compared to growth and value, but with market volatility still a primary consideration and many investors favoring defensive sectors, quality stocks and the related exchange traded funds are worth examining in 2019.

The Invesco S&P 500 Quality ETF (SPHQ) , which tracks the S&P 500 Quality Index, is one of the ETFs with a direct emphasis on the quality factor. SPHQ's underlying index includes the S&P 500 members “that have the highest quality score, which is calculated based on three fundamental measures, return on equity, accruals ratio and financial leverage ratio,” according to Invesco.

The $1.17 billion SPHQ, which turned 13 years old last month, holds 100 stocks and has a four-star Morningstar rating.

“Firms with high return on equity and low growth in net operating assets tend to have high free cash flows, which they can use to fund dividend payments and share repurchases or pay down debt,” said Morningstar in a recent note. “Stocks that make the cut are weighted according to both the strength of their quality characteristics and their market capitalization, subject to a 5% cap.”

Inside SPHQ

Even with single-factor strategies, such as SPHQ, there are instances where holdings overlap with other factors. While SPHQ focuses on the quality factor, over 53% of its holdings are also considered large-cap growth or value names.

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. SPHQ has not always focused on the quality factor.

“Prior to June 30, 2010, the fund did not have a quality mandate. On that date it switched to the S&P 500 High Quality Rankings Index following a period of poor performance,” according to Morningstar. “It switched again in March 2016 to the S&P 500 Quality Index, which applies a more-transparent quantitative methodology. Invesco cited this transparency as the reason for the change. Because of these changes, the fund does not have a long record tracking its current benchmark.”

The quality factor is, at least in theory, sector agnostic. SPHQ allocates over 30% of its weight to technology stocks and a combined 22.37% to healthcare and consumer staples names.

Morningtar boosted its rating on SPHQ to Silver from Bronze.

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