QUAL: Quality Score Ignores Key Sub-Sectors – iShares Edge MSCI USA Quality Factor ETF (NYSE:QUAL)

Index funds should have a place in most retail investors’ portfolios. If anything, to protect against underperformance compared to “market”. Also, index funds can help investors get a sense of security in their equity holdings, allowing them to take more risk in their individual stock positions. Of course, this sense of security is relative to equity performances, not relative to capital preservation, but the sentiment remains. However, not all index funds are created equal. Below, I’ll review the iShares Edge MSCI USA Quality Factor ETF (QUAL), an index fund tracking the MSCI USA Sector Neutral Quality Index.

Asset Management Strategy

As an index fund, QUAL tracks its underlying index. The underlying index focuses on key factors it considers as reflections of quality companies – low leverage, earnings variance, and ROE. From the index’s fact page:

“A composite quality z-score for each security is calculated by combining Z-scores of three winsorized fundamental variables namely, high Return-on-Equity (ROE), low leverage and low earnings variability. A sector-relative quality score is then derived from the composite quality z-score. It is arrived at by standardizing the composite quality z-score within each sector.”

In layman’s terms, the index separates stocks by their sectors, creates a bell curve based on the three factors mentioned above, removes outliers, then determines weight by the product of their quality score and market cap.

Relying on three factors to determine “quality” will of course cause debate. A company may take on massive amounts of debt, which results in a boost to ROE. Although this could result in a net neutral effect for its quality score, the actual “quality” of the stock will likely differ in theory compared to its weight/score.

Performance

As a passive index, it is important to consider past performance. While past performance is only a factor, and past performance is not a guarantee of future results, for ETFs and passive funds, it remains an important factor to consider. Below is a comparison of QUAL’s returns versus the iShares Core S&P 500 ETF (NYSEARCA:IVV) and the iShares Core Dividend Growth ETF (DGRO):

*Since Inception

QUAL lags the S&P 500 by a small amount over the last year, and trailing three years. QUAL underperforms DGRO by a wider margin during those time periods as well.

In addition to returns, the measures of volatility are below. Theoretically, this measures the level of market risk in the funds.

Source: Portfolio Visualizer (link here)

Overall, despite a minute amount of underperformance relative to peers, QUAL largely trades along with the market. However, the difference between DGRO and QUAL borders between insignificant and meaningful, requiring investors to dive deeper into sector allocations and top holdings when deciding between the two, or other index funds. For investors interested in DGRO, I wrote about it last quarter.

Top 10 Holdings

Below is the list of the top 10 holdings of QUAL, along with their fair value as measured by Morningstar. These 10 holdings make up about 33% of the fund.

(*Alphabet Class A and Class C combine to make up 3.56% weight)

QUAL’s top holdings represent a diversified portfolio, albeit more top heavy than other index funds.

Facebook (FB) – Facebook is constantly in the news over data privacy, fake news/regulations, and other issues that bring Facebook headline risk. But Facebook is still posting above 20% top line growth, with net margins above 30%. A healthy balance sheet and lack of China exposure insulate it from the trade war or recession fears, but by far the greatest risk remains regulations and upper management strategy execution.

Johnson & Johnson (JNJ) – Johnson & Johnson has a fortress balance sheet, and is one of the most respected blue chips out there. Similar to Facebook, Johnson & Johnson is subject to headline risk, with focus related to Medicare for All ideas impacting the entire sector. According to Barclays, Johnson & Johnson is still seeing strong growth rates in China in all business units, easing trade war concerns. The Talc litigation should begin wrapping up this summer, possibly removing the largest concern.

Mastercard (MA) and Visa (V) – Both payment processors are trading at high valuations, but these companies are in an oligopoly with massive moats and high margins. The shift away from cash remains a strong secular growth driver, and both companies are either close to, or above, double-digit revenue growth. Outside of valuations, both payment stocks remain excellent investments with favorable trends, wide moats, and high ROIC.

Apple (AAPL) – Apple has been uncharacteristically risky and volatile since the trade war started, as well as due to international pricing concerns. Eventually, services will make up a larger amount of the revenue mix, which will reduce the amount of cyclicality of financial performance. The Apple Card will likely be the next catalyst for the stock, but with earnings potential heavily influenced by trade concerns, Apple will likely underperform in the short term as investors decrease China exposure.

Lockheed Martin (LMT) – Lockheed remains one of my favorite stocks, appreciating by almost 30% YTD. In Q4 2018, I thought Lockheed would be a natural hedge against trade war escalation, but I was wrong in my thesis. However, Lockheed still outperformed the market so far this year, and concerns with a democrat led house affecting military spend have yet to materialize. I still believe Lockheed Martin benefits from a deterioration in China negotiations, and with escalations in Iran, along with Saudi sales, I remain bullish on Lockheed Martin. In terms of QUAL, I believe Lockheed is an interesting fit here, as their large debt load inflates their ROE, and it’s curious that QUAL’s quality score doesn’t filter out Lockheed.

Sector Diversification

Next is a higher level view, comparing QUAL’s sector exposure to its peers.

QUAL’s exposures mirrors the S&P 500 by design. Theoretically, QUAL picks the highest quality picks in each sector, which should provide stability and overall outperformance. However, as reviewed above, this has not been the case.

Information Technology – IT is the largest sector in QUAL. Disappointingly, and surprisingly, I would consider the IT holdings in QUAL as not being an accurate representation of the overall sector. Specifically, cloud computing and enterprise software stock exposure is lacking severely. “Cloud Kings” such as Salesforce (CRM), Adobe (ADBE), and ServiceNow (NOW) are not represented in the ETF, neither is top performer Microsoft (MSFT). QUAL doesn’t have a large exposure to semiconductors either, which helps lower risk from the trade war. Overall, the lack of software exposure limits the upside. Also, this represents a use case for understanding what is in index funds, as investors that are bullish on the software sector may reconsider QUAL, either in terms of ignoring the fund, or buying the fund due to large cloud exposure elsewhere, etc.

Financials – Similar to the IT exposure, just because QUAL has similar exposures as the S&P, doesn’t mean their exposures are equal, or even similar. In the financial sector, QUAL has none of the big banks, nor Berkshire (NYSE:BRK.A) (BRK.B). Again, there is good and bad in this. Investors that see banks as undervalued and view a recession as not imminent, they may decide to look elsewhere. However, investors that don’t want banking exposure may be more attracted to QUAL than other funds. Overall, this is more up to investor preference.

Healthcare – Johnson & Johnson, Amgen (AMGN), and Eli Lilly (LLY) represent over half of the healthcare exposure. In terms of sector balance, QUAL notably doesn’t have exposure to the healthcare providers such as UnitedHealth (UNH) and Humana (HUM). Although this limits exposure to the Medicare for All risks, the entire sector would likely suffer if the proposal picks up steam. In addition to UnitedHealth, Pfizer (PFE), Medtronic (MDT) and Abbott Laboratories (ABT) are all absent from the fund. These stocks are all typically considered blue chips, which is interesting that they are all left out.

Communication – Six companies represent the communication sector, with Facebook, Disney (NYSE:DIS) and Alphabet (GOOG)(GOOGL) making up the vast majority of the exposure. Unlike the other sectors above, QUAL likely has the highest growth potential mega caps in the new communication sector. Notably, heavyweights Verizon (VZ) and AT&T (T) are left out. AT&T is understandable, but Verizon should’ve been close to making the cut off. Alphabet is in a “show me” stage in their lifecycle, as investors are still waiting for Google Cloud to join the heavyweights, and for their other bets to start taking shape, whether through Waymo, Verily, or others. The main takeaway is that investors shouldn’t see their communication exposure as defensive, as these stocks aren’t low beta as communication stocks used to be.

Consumer Discretionary – Discretionary is the last sector that has at least 10% weight in the fund. Of all the sectors, discretionary is the least surprising in terms of holdings. Starbucks (SBUX), Nike (NKE), TJX (TJX), Booking Holdings (BKNG), and Lowe’s (LOW) represent most of the discretionary exposure. Top performers Ulta Beauty (ULTA) and Lululemon (LULU) are also represented, but at much lower weights.

Overall, the sector exposures require further analysis when investors are evaluating the fund. Just looking at the sector breakdown is misleading, and investors need to perform lower level due diligence on QUAL versus other index funds. Investors that are bearish or don’t want exposure to cloud computing, healthcare providers, and banks, but still want an index fund, could consider QUAL an excellent choice.

Investor Takeaway

When evaluating an index fund, it’s important to do due diligence, as the high level view can be misleading. QUAL is the perfect example of this, as the fund lacks exposure to notable sub-sectors such as banks, cloud computing/enterprise software, and healthcare providers.

Taking a real life example, the thought process I have is as follows: I have high exposure to software stocks between my individual holdings and one of my 401k funds, I view banks as cheap, and I believe the Medicare for All hype is overblown. For my personal case, although I appreciate the low software sub-sector exposure, DGRO’s exposure to healthcare providers and banks fit my preferences better. In terms of quality, I’m suspicious of QUAL’s quality score, and even though determining “quality” stocks is much more complicated than a few rules can achieve, I prefer the dividend growth history in DGRO over QUAL’s quality score.

Disclosure: I am/we are long DGRO, UNH, LMT, ULTA, MSFT, CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The above references an opinion and is for information purposes only. This information is general in nature and has not taken into account your personal financial position or objectives. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. Past performance is not an indicator of future performance.