- Among a comprehensive group of the quality categories used by practitioners, capital structure, earnings stability and growth in profitability show little evidence of premia, whereas profitability, accounting quality (few accruals), payout/dilution and investment tend to be associated with premia (and provide credible models that motivate the phenomenon); further, profitability and investment-related characteristics tend to capture most of the quality-related premia.
- Characteristics, such as low book leverage and low earnings growth volatility, appear to be overly related to the low-volatility characteristic to warrant independent consideration.
- The correlations of returns among the six index providers reveal a lack of similarity, indicating they are not proxies for a common hidden factor, suggesting these leading quality index products are a collection of heterogeneous attributes linked by the theme of financial and accounting quality.
- No evidence exists that the six indexes proxy for a unique homogeneous source of risk or a single anomaly. Therefore, quality indexes are more appropriately interpreted as multifactor portfolios, the primary commonality is that they are constructed mostly from the less well-known and less vetted firm characteristics.
I would add the following warning. While premiums resulting from risk-based characteristics cannot be arbitraged away (though cash flows to exploit premiums can cause them to shrink), behavioral characteristics are more susceptible to arbitrage, especially in large stocks where limits to arbitrage (that prevent mispricings from being corrected) are less present. Quality companies tend to also be large companies. Thus, limits to arbitrage play a much lesser role. In other words, buyer beware. There is one more important point we need to cover.
All of the selected quality characteristics are viewed as being attractive firm attributes, those characteristics investors would generally be willing to ‘pay up’ for. Implicit in the design is that the high-growth and high-profitability firms with low debt and conservative accounting practices are underpriced and thus generate high returns! This should raise alarms for the economists among us. It’s not just a free lunch, it’s a free feast!
Indirectly Gaining Exposure to QualityWhile some value strategies use the single metric of P/B to determine value, others include other metrics such as P/E and P/CF. The metrics which include earnings-related measures provide exposure to the profitability factor (and the related quality factor). Thus, providing exposure to traits which Hsu, Kalesnik, and Kose found passed their tests. As examples, in their portfolio construction design, Dimensional’s value funds now use not only P/B but also a measure of profitability. AQR Capital Management’s value funds, in addition to using P/B, also use P/E, P/CF, price-to-forecasted earnings and sales-to-enterprise value. In other words, you can gain exposure to profitability and quality indirectly through investments in value funds that use metrics other than P/B. And multifactor funds are more efficient than single-factor funds. One reason for this is that, if you use the component approach, you could have one factor-based fund buying a stock (or group of stocks), while another factor-based fund will be selling the same stock (or group of stocks). For example, if a stock (or an entire sector) is falling in price, it might drop to a level that would cause a value fund to buy it, while a momentum fund would be selling the very same security. Investors would thus be paying two management fees and also incurring trading costs twice, without having any impact on the portfolio’s overall holdings.
SummaryHsu, Kalesnik, and Kose show that, when selecting funds to gain exposure to desired traits/characteristics, investors need to dig deeper than just relying on a fund’s name. Fund construction rules matter a great deal. And while it’s important to consider a fund’s expense ratio, fund construction rules can matter more than fee differentials.
We observe that most of the indices use at least a few non-robust measures in their definitions. Jason Hsu, Vitali Kalesnik, and Engin Kose; What is Quality