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Quality Investing, an All-Weather Approach

8 July, 2021

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WisdomTree

It is turning out to be another eventful year in equity markets. Sector rotation, policy largesse, the everything rally – investors have much to contend with. And while this may turn out to be another strong year for equities, it may look very different under the hood compared to last year.

By Pierre Debru, Director, Research at WisdomTree

It is turning out to be another eventful year in equity markets. Sector rotation, policy largesse, the everything rally – investors have much to contend with. And while this may turn out to be another strong year for equities, it may look very different under the hood compared to last year.

Growth, a factor that focuses on businesses with strong growth prospects, had been outperforming Value for many years, mainly thanks to the technology sector. The first quarter of 2021 saw under-priced stocks lift Value over Growth. In April, however, Growth bounced back as strong earnings in the tech sector buoyed markets yet again.

But then markets were reminded of rising levels of inflation, especially in the US. Now inflation, in theory, should be supportive for equities, particularly if it is driven by an increase in aggregate demand in the economy. But rising levels of inflation tend to worry equity investors due to the prospect of monetary policy tightening from central banks. The risk, therefore, is less about inflation and more about policy errors.

In an environment where risks still abound, performance may come from different parts of the equity spectrum, and sector rotation may happen many times, building a diversified portfolio warrants consideration – to not only reduce the risks but also benefit from the opportunities.

Quality Investing an all-weather type approach

At WisdomTree, we believe that using Quality factor and quality companies as a core, strategic allocation can lend strength to portfolios. Quality is a factor that has been endorsed by both academics as well as industry practitioners. In 2014, Fama and French adapted their 3-factor model to include two new factors – one of which was profitability, demonstrating that companies with higher profitability tend to outperform over the long term. Since the turn of the millennium, global quality stocks have outperformed the market by an annualised rate of 2%1.

Quality is not the only equity factor expected to outperform the broader market over the long term harnessing some unique risk premium. All equity factors are expected to do so. However, each equity factor tends to behave differently depending on the market environment and, therefore, tends to deliver its long-term outperformance in a unique way. Quality’s merit lies in its balance between downside protection and upside participation.

Those differences between factors can be observed in Figure 1 using the Upside Capture Ratio and the Downside Capture Ratio of the 6 classic equity factors plus WisdomTree’s own approach to Quality. The Upside Capture Ratio is the proportion of market gain captured by a strategy when markets go up, and the Downside Capture Ratio is similarly the proportion of market losses endured by a strategy when markets go down.

In Figure 1, we observe that Minimum Volatility, for example, tends to be very defensive, with a low downside capture but also a low upside capture. Therefore, it tends to perform well in market corrections but to lag significantly in bull markets.

On the opposite side, Value tends to outperform and deliver above-market performance in periods of economic recovery and strong bull runs, but it struggles during bear markets.

Quality, on the contrary, tends to behave evenly across the business cycle. It offers a low downside capture, which means it tend to behave quite defensively in downturns. However, the upside capture is very close to 100%, meaning that it tends to capture a large share of the upside in bull runs. This is why we favour Quality as an all-weather core exposure in the portfolio.

Upside and Downside Capture Ratio of Equity Factors

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Source: WisdomTree, Bloomberg. Period September 2002 to March 2021. Calculations are based on monthly returns in USD. The inception date for the WisdomTree Global Quality Dividend Growth Index is 16 October 2015. You cannot invest directly in an index. Above numbers include backtested data. Historical performance is not an indication of future performance and any investments may go down in value.

WisdomTree’s approach to Quality investing

Turning to our approach to Quality investing, we subscribe to the notion of profitability as a useful measure for defining Quality. We believe that it’s important to not dilute the potential power of Quality by applying too many stock selection rules or complex weighting schemes. In our view, the key is to be as broad-based and straightforward as possible while still focusing on companies with a high return on equity and low debt – attributes that are commonly considered to be fundamental in Quality investing.

Source:

  1. Bloomberg, data as of 18 May 2021 based on the comparison between MSCI World Quality Net Total Return USD Index and MSCI World Net Total Return USD Index.

Min Volatility means MSCI World Min Vol Net TR Index. Quality means MSCI World Quality Sector Neutral Net TR Index. Value means MSCI World Enhanced Value Net TR Index, High Dividend means MSCI World High Dividend Net TR Index. Size means MSCI World Small Cap Net TR Index. Momentum means MSCI World Momentum Net TR Index. WisdomTree Global Developed Quality means WisdomTree Quality Dividend Growth net TR Index


To learn more about Quality investing, please visit wisdomtree.eu

This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.