VFQY ETF: A Data-Driven Approach To Quality Investing (BATS:VFQY)

The Vanguard U.S. Quality Factor ETF (BATS:VFQY), is an actively managed fund which evaluates companies based on factors considered to be indicative of high-quality earnings. The fund uses the Russell 3000 as its benchmark, and the managers look across the market cap spectrum to build the portfolio.

We have faith in the quality factor in general to boost long-term returns, we see VFQY as an attractive option to unlock this factor in our own portfolio.

Background on the Quality Factor and VFQY

Quality is one of the many factor anomalies seen when researching historical returns of equities, along with size, value, momentum, to name a few. The discovery of these factors was first brought to light in 1992 by Eugene Fama and Kenneth French, identifying the size, value and momentum factors first to create the “Fama-French 3 factor model”. Since then, more research has been done which identified the profitability factor (also referred to as quality) and the investment factor. Amongst those factors quality has been shown to outperform compared to the others over time, as seen in the chart below.

This is also seen on a risk-adjusted basis, evidenced by the table below, with a better risk return ratio than all other factors except for low volatility.

However, one thing that makes investing in the quality factor more difficult compared to other factors is that the definition of what makes up a “quality” company is loose, and practitioners have not settled on a strict methodology. This contrasts with the value factor for example, which is defined as companies with low price-to-earnings or price-to-book ratios.

VFQY uses return on equity, gross profitability, change in net operating assets and leverage to measure the quality factor. SPHQ, the Invesco S&P 500 Quality ETF uses return on equity, accruals, and leverage. QUAL, the iShares MSCI USA Quality Factor ETF, on the other hand, uses return on equity, stable year-over-year earnings, and leverage to measure quality. Because definitions of quality can vary, it is important to look at which definitions have been shown to be the most effective when comparing quality ETFs.

A study from the Financial Analysts Journal breaks the quality factor down into 7 categories, which include profitability, earnings stability, capital structure, growth in profitability, accounting quality, payout/dilution and investment. In their analysis, profitability, payout/dilution, accounting quality, and investment were found to deliver superior performance based on multiple types of statistical analysis. Little evidence was found that earnings stability, capital structure, and growth in profitability were associated with superior performance, based on not only their study, but also when looking through previous research conducted. Because of this, we believe that metrics associated with profitability, payout/dilution, accounting quality, and investment should be used by quality funds to deliver superior performance.

The table below shows which category each metric that VFQY, SPHQ, and QUAL use to select securities fall under. The green cells indicate that metric was shown to generate superior returns. Growth in profitability and payout/dilution metrics were not used as metrics by any of the funds so they are not included in the table.

We see that VQFY uses three metrics that are associated with the categories shown to deliver superior returns, compared to only two and one metrics for SPHQ and QUAL, respectively. We see this as evidence that VFQY has a better security selection process than the other two funds.

Continued Comparison of Quality ETFs

The table below compares these funds on more interesting metrics.

Click to enlarge

VFQY has by far the lowest AUM and weighted average market cap. The low assets are likely due to the fund being relatively new versus the others, and also because it has underperformed relatively.

As for the much lower weighted average market cap, this will certainly make the fund more volatile, and is probably a reason for underperformance due to the outperformance of large cap. However, the benchmark for the fund is the Russell 3000, so the size difference makes sense. VFQY is much more diversified than the other two funds while also much cheaper with a P/E ratio less than 15. The dividends and expenses for the funds are all relatively comparable, with expense ratio ranging from 13 to 15 bps.

Holdings

See below for the top 10 holdings of the fund.

Risks of Quality Investing and VFQY

Quality investing may have significant periods of underperformance compared to the market and other factors. The table below from WisdomTree, shows that in 10 year rolling periods, quality’s best outperformance versus the market was the lowest of all the factors, at only 3.1%. However, this is made up for the fact that quality’s worst underperformance was the lowest at only -1.5%. Also, quality outperformed in the highest percentage of periods, at 88%.

Conclusion

We see quality as an important allocation to our portfolio, due to its historical outperformance both on a return and risk-adjusted basis. Based on empirical research referenced, we see that among the funds looked at, VFQY used the most metrics that were shown to provide superior returns in their security selection process. Additionally, the fund has a much more attractive valuation than its peers. For these reasons, we rate VFQY a Buy.