BMO has launched three so-called “Quality ETFs” so far this year: the BMO MSCI Europe High Quality Hedged to CAD, the BMO MSCI All Country World High Quality Index ETF and the BMO MSCI USA High Quality Index ETF. In contrast with a lot of the investment products on the market, there is scientific evidence that “quality” stock portfolios benefit from a higher-than-average expected return. What is a quality index? Why does it matter? What are the risks involved with this approach?

What Is a “Quality” Stock Index?

A quality index includes the companies within the stock market that have high and persistent profitabilityi and low debt. In fact, “quality” is often referred to as “profitability” in the scientific literature.

Why Does “Quality” Matter?

Quality is part of the factor-based approach to investing. This approach suggests that a portfolio’s returns are determined by its characteristics (or “factors”), rather than by the manager’s efforts to pick good securities. According to scientific evidence, increased exposure to stocks (relative to bonds), to value stocks (relative to growth stocks) and to small cap stocks (relative to large cap) results in a higher expected return. In the same vein, recent research supports the view that increased exposure to quality stocks (all else remaining constant) also results in a higher expected return.

A more detailed and authoritative explanation of the quality factor can be found in this paper from Robert Novy-Marx (University of Rochester).

Three Risks of Quality Investing

The quality factor has significant evidence in its favour, but investors must consider the following risks:

  • Behavioral risk: A high-quality portfolio will likely select a limited subset of stocks. As a result, its composition will be extremely different from the overall market’s. Due to this difference, it can occasionally underperform the general market for several months or even years. Investors must be ready not to abandon their strategy during these tough times.
  • Size and style drift: “Quality” or “profitability” works best when other factors are held constant. A portfolio that focuses solely on profitability will end up with mostly Large Growth stocks, a bias that will likely offset some of the benefits of high quality.
  • The past is not prologue. While the quality stocks have outperformed in the past, this excess return may not show up in the future. “Quality” investing, like all other factor-based strategies, is not a sure-fire way to higher returns.

How Does PWL Integrate Quality in Client Portfolios?

Dimensional Fund Advisors equity funds, which are major components in most PWL client portfolios, integrated the quality factor into their portfolio process two years ago. During our continuous due-diligence review, we observed that Dimensional executes the strategy in a very thoughtful, balanced and responsible way that captures most of its potential benefits while minimizing the risks.

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i Operating Profit / Book Equity ratio