https://www.morningstar.com/funds/these-etfs-increase-return-without-adding-risk
Please read more at the above link
In 2018, research by Jason Hsu, et al, looked at the many definitions of quality and ultimately found evidence that the following indicators deliver superior performance:
- Profitability
- Accounting quality
- Payout/dilution
- Investment—with the caveat that its edge can be explained by other factors in a multifactor model.
To expand on Novy-Marx’s explanation above, quality companies carry productive assets that can be reliably accounted for in financial statements and won’t be diluted away by the company issuing new shares.
Why Does Quality Investing Work?
Quality wouldn’t work if markets were highly efficient. The quality factor’s risk premium signifies that those companies are consistently underpriced. How can that happen across geographies and over long periods of time?
Antti Ilmanen, global co-head of portfolio solutions at systematic investing titan AQR, called out a few behavioral biases and explanations for why quality works in his book, Investing Amid Low Expected Returns. They include investors’ preference for stocks that perform like lottery tickets, constraints against leverage, and “story-oriented” analysts/investors.
- Preference for lotteries, or stocks with high potential return, has taken center stage in a market fueled by crypto, meme stocks, and leveraged single-stock exchange-traded funds. Buying into bitcoin a decade ago was like winning the lottery. A gambling mentality pushes some investors to take big risks in the hopes of hitting home runs when they could more easily (and more safely) compound doubles with the quality factor.
- Some investors may not be able to use leverage. That constraint shifts their focus from risk-adjusted returns to total returns, which pushes them into riskier assets and leaves high-quality companies behind.
- Story-oriented analysts and investors buy narratives not fundamentally sound businesses. That typically excludes high-quality stocks from their portfolios.
Adding my own thought to the mix: Quality works because investors seek out core/satellite portfolios. Broad market funds form their core holdings. They’re unlikely to add a fund with similar holdings and returns. Quality factor ETFs fit that mold. They often hold many of the large stocks that dominate the market, so it’s reasonable for investors to seek more differentiated strategies for their satellite position(s).