WHAT IS QUALITY INVESTING?

• Quality investing targets companies with a consistent track record of strong earnings and stable balance sheets.
• Quality investing has been around for decades and is supported by economic theory and empirical data.
• Quality strategies may use a combination of metrics such as profitability (ROE), earnings stability, and low leverage (D/E), to identify firms with strong earnings and stable balance sheets.

Imagine that you’re at the grocery store and looking to buy fruit. You notice today that the organic apples are priced the same as the non-organic apples. Given the current prices, you opt to buy the “higher quality,” organic apples. Think of quality investing in a similar light. Quality investors are looking to get more for their money.

Quality, like all our factor investing options, has an economic rationale for why it has existed historically, and more importantly, why we expect it to persist going forward.

Return-on-Equity (ROE) evaluates a company’s profitability by dividing its net income by its shareholder’s equity, or a company’s total assets minus its total liabilities. This metric measures a company’s ability to generate profits from shareholders’ investments in the company. A higher ROE typically indicates a more profitable company.

Debt-to-Equity (D/E) measures a company’s financial leverage by comparing its total debt relative to its total equity. A high debt-to-equity ratio can indicate that a company is relying heavily on debt financing, which may be an indication of increased financial risk.

Earnings Variability measures a company’s ability to consistently generate stable growth in earnings over time. A company with stable earnings through economic cycles may be considered all weather and less risky. As expected, the quality factor portfolio/index¹ has both higher ROE and lower debt-to-equity when compared to the MSCI World Index.

When building a quality portfolio, there are several key decisions on how to construct the strategy. For example: Should there be any constraints on sectors? How should companies be ranked against others?

Sector deviations are an element of risk that we can control, and we believe that it makes the most sense for sectors to be constrained. In other words, sector weightings should be similar to the broad market. This enables quality investors to gain exposure to the highest-quality earnings across all sectors, without making unintended bets on specific sectors. Historically, static overweight exposures to sectors have not exhibited significant long-term excess returns above the market.²

Additionally, we believe it is prudent to compare quality characteristics of a company relative to its peers in the same sector. Sector comparisons allow companies to be scored on equal footing.

As highlighted in the chart below, the MSCI World Sector Neutral Quality Index has very similar sector allocations to the MSCI World, whereas the MSCI World Quality Index has significant overweight to tech and healthcare, and underweights to energy, real estate, and utilities.

Sector Weights

Quality investing is all about identifying financially healthy companies with strong balance sheets. It’s backed by economic data and academic research.^3/4

Investors also need to be aware that international investing often comes with exposure to foreign currency movements, which can have a significant impact on returns. The more volatile the exchange rate between two currencies, the higher the risk and potential impact on returns. Investors wishing to reduce this volatility, can opt for the hedged version which can help minimise unintended currency bets. 

Accessing quality through low-cost ETFs such as the iShares MSCI World ex Australia Quality ETF (IQLT) and iShares MSCI World ex Australia Quality (AUD Hedged) ETF (IHQL) allows investors to gain exposure to a diversified portfolio of stocks that look strong on multiple quality metrics — profitability, leverage, and earnings variability — and limiting unintended sector bets.