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Equity markets have staged dizzying swings in 2020, first falling sharply then rallying back in response to evolving news about the global pandemic.

Buffering a portfolio against a market downturn can be difficult even in normal times, and such complications are compounded many times over as we adapt to this “new normal” of heighted volatility.

In my recent conversations with clients, the topic of seeking out quality-focused equities amid the ongoing uncertainty comes up again and again. Quality strategies seek exposure to companies with stronger balance sheets and more stable earnings than their peers.

Stocks with these attributes have tended to be popular in challenging market environments. In fact, year-to-date flows into the iShares Edge MSCI USA Quality Factor ETF (QUAL) have totaled $2.5 billion as of May 31, 2020, making it the second-largest asset gatherer among smart beta ETFs1. The international version of the same strategy, iShares Edge MSCI International Quality Factor ETF (IQLT), has pulled in $385 million over the same time period.

I often get three questions around this topic, which I’ll address in this post:

    1. Why seek to add quality to portfolios?
    2. How is quality defined?
    3. How can an international allocation to quality be beneficial?

Why seek to add quality to portfolios?

Investors are increasingly turning to the quality factor today on account of the changing economic environment. In its latest update, the BlackRock Investment Institute noted that the U.S. economy is firmly in a contraction. Research has shown this stage in the economic cycle has tended to favor defensive factors such as quality. Quality generally performs best in economic slowdowns and contractions making this factor a potentially attractive investment option in the current environment.

Typical quality factor behavior throughout a global business cycle

Illustration showing quality as the factor that has historically performed best during the slowdown and contraction phases of the economic cycle.

For illustrative purposes only.

And while quality might historically be among the best-performing factors during economic declines, it can also prove additive across the cycle broadly. Over the long-term, the quality factor2 has outperformed the Morningstar Large Blend Category peer group by 2.0% and the broader market by 0.9% on an annualized basis as of May 31, 20203. In addition to better returns, as you can see below, the quality factor has delivered lower risk, a lower maximum drawdown, and a lower average down capture. Performance relative to the broader market does not necessarily indicate positive returns.

Cumulative performance since index inception

Line graph showing cumulative performance of the quality factor versus the S&P 500 and the Morningstar US Large Blend fund category from 12/12/2014 to 4/30/2020.

Source: Morningstar, from 12/12/2014 to 4/30/2020. Outperformance relative to the S&P 500 index does not indicate positive returns. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

 

Return % Standard Deviation % Max Drawdown % Up Capture % Down Capture %
Quality factor 9.3 14.3 -19.4 96.9 92.6
S&P 500 8.9 14.5 -19.6 - -
US Fund Large Blend Category Average 6.5 14.4 -20.9 92.5 104.0

Source for above chart and table: Morningstar, 12/12/2014 to 4/30/2020. Quality Factor is represented by the MSCI USA Sector Neutral Quality Index. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

How is quality defined?

BlackRock believes in a diversified, robust three-pronged definition of quality. We think a company that historically has had stable earnings may be more likely to generate returns across the entire economic cycle. Being more profitable may signal that the company has a more durable business model than peers. Finally, having lower leverage may give companies the flexibility to optimize their cash flow away from servicing debt during times of stress. Three examples of companies we look to include:

1. Payment companies like Mastercard and Visa have been exposed to powerful digitalization trends in recent history benefiting from the increase in online consumer spending. Recently, both are moving towards opportunities in data-driven services, which would potentially provide diversified sources of revenue. Their business models have helped limit cyclicality in revenue and earnings. MSCI provides a quality score to each company within the MSCI USA index that is comprised of the company's Return on Equity, Earnings Variability and Debt to Equity. Relative to all other companies in the Technology sector, Mastercard scores4 the best on both earnings variability and profitability.


2. Nike and Under Armour are both global brands exposed to trends in athleisure and are GDP-linked businesses. Despite operating in the same industry, differences in their growth strategies have likely contributed to a division in financial performance. Among the differences, Under Armour invested mainly in the North American market, while Nike continued to invest globally. This geographic diversification is one factor that may have contributed to greater stability in earnings for Nike over the long term.


3. Oracle is an example of a profitable technology company that has been often overlooked in the rush towards “growthier” names in the new technology stack. The company is cash-rich, maintains low debt levels relative to peers, and has generated relatively stable earnings. In the peak of uncertainty in March 2020, Oracle signaled that they would conduct buybacks worth $15 billion5 – which many investors interpreted as a sign of sound balance sheet management.


Source: MSCI, Mastercard, Visa, Nike, Under Armour and Oracle. This is not meant as a guarantee of any future result or experience. This information should not be relied upon as research, investment advice or a recommendation regarding the iShares Funds or any security in particular. For actual iShares ETF holdings, please visit www.ishares.com. Specific companies or issuers are mentioned for educational purposes only and should not be deemed as a recommendation to buy or sell any securities. Any companies mentioned do not necessarily represent current or future holdings of any BlackRock products.

How can an international allocation to quality be beneficial?

A BlackRock study of over 15,000 advisory portfolios in December 2019 noted a decline in allocations to international developed equities across all types of risk tolerances compared with the previous year. Since the behavior and characteristics of the quality factor persist across markets, international quality can be a powerful tool for investors looking to re-enter international markets or reduce home country bias.

Average allocation to international developed stocks

Chart showing a decrease of investor allocation to international developed markets across risk profiles from 2018 to 2019.

Source: Spring 2020 Advisor Insights Guide, data as at 31 Dec 2019.

Summing it up

The world is changing rapidly and, in turn, so are operating conditions for companies. No one can foresee the trajectory of economic recovery with much certainty. This ambiguity brings great challenge for investors of all horizons. Timing the market is hard even for the most experienced investor, which is why we continue to advocate for stable, diversified portfolios across asset classes for the long run. However, within domestic and international equities, increasingly clients are looking at the merits of an allocation towards quality companies to provide a greater measure of resilience during these uncertain times.

Holly Framsted, CFA
U.S. Head of Factor ETFs
Priya Panse, CFA, Bobby Johnson, CFA, and Elizabeth Turner, CFA contributed to this article
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