GMO: the quality anomaly

David_Snowball

Nice piece today from Ben Inker, co-director of GMO's asset allocation team. Timed to reflect the launch of their US Quality ETF, Inker argues that "quality" is systemically mispriced - that is, underpriced in one market cycle after another - for both equities and high-yield bonds. As a result, "quality" should be considered an investor's one permanent bias in portfolio construction.

As GMO launches its first ETF, it seemed like a good time to share my thoughts on the market inefficiency that the strategy seeks to exploit ­– the quality anomaly. The basic goals of any active investor are to achieve higher returns and/or lower risk than a passive portfolio. These goals are, or at least should be, in conflict with each other. If financial markets were efficient, it would be impossible to sustainably achieve higher returns without taking on additional risk. And any portfolio that embodied lower risk would pay for it with lower long-term returns. At the highest level, markets basically work this way. Government bonds and cash are lower risk than high yield bonds and equities and have delivered lower returns across almost all markets and most time periods. But within risk assets, things get weird. Within both stocks and high yield bonds, you have historically been able achieve both higher returns and lower risk by owning the highest quality securities in those universes. This quality anomaly has been around for a long time and exists within multiple subsets of the equity universe. And for what it is worth, their opposite numbers have also been mispriced – low-quality stocks and CCC (and below) bonds have underperformed their broad universes despite their obviously greater downside in bad economic times. In an investing world where most trade-offs are difficult, this one is pretty easy. If you were going to have one permanent bias in your equity and high yield bond portfolios, it should be in favor of high quality.

He looks at the returns and volatility for higher quality vs lower quality in US stocks, high-yield (BB vs CCC) bonds, small cap stocks, global stocks and value stocks.

Looking over a 20-year period, higher quality stocks in various classes return maybe 400-550 bps more than low quality stocks yet suffer something like 400 bps less in volatility.

I've included a link, but I suspect you'll hit a wall. Happily, at least in my case, registration was free and quick. The argument is worth considering.

BaluBalu

Thank you David for sharing.

"If you were going to have one permanent bias in your equity and high yield bond portfolios, it should be in favor of high quality." (Underline added)

I own Quality in my portfolio in the hope to lower volatility of my portfolio without decreasing total returns over a long period of time. I think Quality performs by losing less in a down market. Over shorter periods, SPY total return can beat Quality.

hank

d

fundly

You get this information only within your brokerage account

WABAC

If you were going to have one permanent bias

Interesting choice of words.

And how does one define quality in equities and bonds? Is it the way we understand pornography, we know it when we see it?

BenWP

My reaction also, @WABAC. I see "quality" showing up in the names of numerous equity funds. For example, VettaFi lists 25 ETFs characterized as « quality factor. » (I don't know about bond funds.) Surely the managers of these strategies differ in their approaches to quality in the same way that "growth" or "value" managers differ in how they pursue their goals. M*’s use of the term in assessing a fund’s portfolio lacks the descriptiveness of measures such as size, momentum, yield, or volatility. Quality may be easier to assess after the fact, but its use as a predictor of performance might be unreliable.

WABAC

@BenWP, we don't have to travel far in these forums to find posters discussing the virtues of managers that invest in junk.

Maybe it's quality junk?

Old_Joe

Interesting concept... good junk vs junky junk. Of course I poke fun here, but there actually may just be something to that.

WABAC

Old_Joe said:

Interesting concept... good junk vs junky junk. Of course I poke fun here, but there actually may just be something to that.

Do any fund managers claim to be looking for the cra . . . crummiest assets they can find?

Sven

Liz Ann Sonders often talked about investing in “quality” stocks. Quality was refer to those with consistent earning and wide moat business model.

Mark

@WABAC - you asked "And how does one define quality in equities and bonds?"

GMO's statement of quality (as it applies to QLTY):

"The GMO U.S. Quality ETF seeks to generate total return by investing in U.S. equities the Focused Equity team believes to be of high quality.

The team believes that companies with established track records of historical profitability and strong fundamentals – high quality companies – are able to outgrow the average company over time and are therefore worth a premium price. The GMO U.S. Quality ETF’s disciplined approach uses both quantitative and fundamental techniques to assess the relative quality and valuation of U.S.-domiciled companies and aims to exploit a long-term investment horizon while withstanding short-term volatility in an actively managed ETF format." Source

Anna

I, for one, would be in the market for quality, good junkie-junk.

WABAC

Thanks @Mark. But what are those "quantitative and fundamental techniques" that sets QLTY apart from FUQIX or QUAL-- just to mention two large blend funds that have quality in their name.

As of this morning, I find 54 US equity funds in the MFO premium database with quality in their name, in addition to QLTY. And many of them charge less than QLTY.

So I am amused by the pitch that GMO alone, has discovered, and can identify, a quality premium.

Mark

@WABAC - I don't know how GMO managers tweak their machines to recognize their definition of 'quality'. As @BenWP noted above "Surely the managers of these strategies differ in their approaches to quality in the same way that "growth" or "value" managers differ in how they pursue their goals."

Likewise I have no clue where your statement "So I am amused by the pitch that GMO alone, has discovered, and can identify, a quality premium." comes from. I didn't find that in GMO's literature.

WABAC

As GMO launches its first ETF, it seemed like a good time to share my thoughts on the market inefficiency that the strategy seeks to exploit ­– the quality anomaly.

Mark

Must be a failure in my reading comprehension skills as that statement doesn't say to me that only GMO "alone" has discovered a quality premium. To me it merely states the strategy they intend to exploit. Please help.

WABAC

Why?

Inker's marketing wryly amuses me. I'm amused he thinks quality is anomalous. I'm amused when he compares stocks to battleships. I'm amused he can't find paragraph breaks. My amusement is not worth beating to death with semantics.

Maybe someday I'll even by QUAL, if it ever gets ahead of TCAF.

BenWP

I’ve been looking at mid-caps and I came across XMHQ, a promising candidate. When researching the « quality » factor for this fund, I found the following description:

The Invesco S&P MidCap Quality ETF (Fund) is based on the S&P MidCap 400 Quality Index (Index). The Fund will invest at least 90% of its total assets in the component securities that comprise the Index. The Index is a modified market capitalization weighted index that holds approximately 80 securities in the S&P Midcap 400® Index that have the highest quality scores, which are computed based on a composite of three proprietary factors. The Fund and the Index are rebalanced semi-annually.

I guess S&P own the recipe to the secret sauce. They don’t appear to want you and me to know what the three proprietary factors are. I suspect further research into « quality » funds will prove equally frustrating.

Mark

So it's the same as the makeup of ESG funds only different. Got it.

Old_Joe

Some of you folks seem to be getting more and more cynical. Given the way that our country and in fact much of the world is operating lately it's pretty easy to understand that.

WABAC

BenWP said:

I’ve been looking at mid-caps and I came across XMHQ, a promising candidate. When researching the « quality » factor for this fund, I found the following description:

The Invesco S&P MidCap Quality ETF (Fund) is based on the S&P MidCap 400 Quality Index (Index). The Fund will invest at least 90% of its total assets in the component securities that comprise the Index. The Index is a modified market capitalization weighted index that holds approximately 80 securities in the S&P Midcap 400® Index that have the highest quality scores, which are computed based on a composite of three proprietary factors. The Fund and the Index are rebalanced semi-annually.

I guess S&P own the recipe to the secret sauce. They don’t appear to want you and me to know what the three proprietary factors are. I suspect further research into « quality » funds will prove equally frustrating.

I have that in the IRA. It might be a better fit for the taxable. I'll probably put that money into FMIMX.

According to etf.com this is the secret sauce:

The equities are selected based on the highest quality score, calculated by the following three equally-weighted fundamental factors: (1) return-on-equity (2) accruals ratio, and (3) financial leverage ratio. The index is being weighted by the total of its quality score multiplied by its market capitalization and is rebalanced semi-annually.

BenWP

Thank you, @WABAC. You're always at least one step ahead of me.

BaluBalu

"Inker's marketing wryly amuses me."

I agree that GMO is an annoying marketing machine. As I mentioned elsewhere, it was ballsy for them to not seed their first ETF - their overconfidence of their ability to market speaks for itself. It started with $3M AUM and got up to $30M as of yesterday (50% increase probably yesterday). The lumpy inflows could have a negative short term impact for existing shareholders.

I have always ignored their public pronouncements. I would not have bought QLTY (an active fund) if we did not have GQETX to look at past performance. If the fund stopped performing against another Quality fund (passive or active), then it is reasonable to bail but comparing it to SPY or other active funds on a short to intermediate term basis may just be a point of entertainment. I think it is fair to compare any investment over one's investment horizon. It is also fair to question whether a retail investor (such as us) should really delve into specific factors.

As I mentioned earlier in this thread, expect Quality to give lower returns when high Beta (or other factors) are in vogue. Also, with only 35 constituents, QLTY returns could be a bit lumpy just as with any focused fund but GQETX returns do not appear to be lumpy - active management?

I would just sit and watch until the fund gets to a reasonable size AUM.

I think posters in this thread raised good points, even if a bit salty! I think it is good when others take the time and effort to question what one is doing. Thanks.

WABAC

BenWP said:

Thank you, @WABAC.

De nada.

BaluBalu

"I have that [XMHQ] in the IRA. It might be a better fit for the taxable. I'll probably put that money into FMIMX."

Do you mind elaborating why you would prefer FMIMX over XMHQ?

Other than in 2022, an unusual set of circumstances, XMHQ seems to have done well.

While I do not generally pay attention to ER, I think you mentioned elsewhere and so I checked. XMHQ ER 0.25% while FMIMX ER is 1%.

WABAC

hi @BaluBalu. It's an ongoing evaluation. There are plenty more things in the IRA to sell before I get around to XMHQ. I killed a lot of flowers and fed a lot weeds when I rebalanced in November 2021. I might just keep it.

Just ran one of my screens at MFO Premium and XMHQ is looking good since Covid (2020/01). OTOH, FMIMX looks good since TGN (2022/01). It's one of a very few SMID funds with a positive Martin ratio number since then.

So it will come down to the risk and volatility numbers going forward. I'm not sure what longer-dated past performance numbers have to say about the environment we are in now, or the one that we may be entering.

As for the price? What else? I like their marketing.

BaluBalu

@WABAC, Thanks.

I think XMHQ in a taxable account makes good sense (you had mentioned this), given how tax efficient it has been.

sma3

I am surprised that a fund like USBOX can mimic GQETX so closely ( even with double the ER) and have only $250 million in assets. I am also a little surprised they can get away with such mimicry but I guess 13Fs are public information. It is also interesting that with almost identical portfolios, GQTEX is a M* Gold fund and USBOX only bronze, presumably because of the ER. But does M* believe someone with $5,000,000 to invest is going to be reading their analysis?

BaluBalu

I tried to buy XMHQ today and the B/A spread is 0.15%. It is a $2B fund but the volume is only 150K, with average volume a bit higher but not large relative to its size. Put in a limit order at the current Bid and waited. Eventually it triggered. I expect it will be the same delayed process when it is time to sell.

I had not previously owned a small or mid cap ETF before.

BaluBalu

@WABAC, Today there is a material difference in performance of XMHQ vs XSHQ. For 2024, do you have a preference between these two?

Mitchelg

Prefer and own XMHQ. Has a terrific track record.