As tapering looms and sustained inflation becomes an increasing concern, Chris Heakes, Director, Portfolio Manager, Exchange Traded Funds (ETFs), discusses the benefits of quality investing in the current environment – and how to efficiently access the factor through a disciplined framework across regions.
A return to a more defensive investment strategy
Tapering, geopolitical risk, rising rates and high inflation. With all these elements at play, institutional investors worldwide are grappling with heightened volatility concerns. While global equities have continued to perform from last year’s Covid-19 related drawdown, Quality can be a strong factor that asset owners and managers can rely on by focusing on companies with competitive advantages that can sustain – expected and unexpected – market turbulence.
Although markets anticipate less disruption than the taper tantrum of 2013, it is likely that institutions will have to revisit their current equity portfolio and reposition to defensive areas that are less affected by the imminent tapering.
As a result, quality trades are gaining traction with institutional investors. In addition to tapering, markets have tended to gravitate towards more defensive growth factors like quality in the years after a market bottom, as easier opportunities in higher beta and small cap sectors begin to dissipate.
Identifying quality with 3 key metrics
The question now becomes, how do you discern quality? At BMO Global Asset Management, our suite of quality ETFs rely on the MSCI world-class leading methodology to identify the best companies globally, allowing us to objectively assess value according to three defining metrics:
- High return on equity (ROE) – intended to screen for the “winners”, this measures the profitability of a business in relation to its equity, or how many dollars of profit are generated per dollar of shareholder equity. Typically, companies with higher profitability are higher quality, outstripping competitors.
- Earnings stability – companies with low earnings variability are seen as less risky, with a sustainable competitive advantage.
- Low financial leverage – businesses with strong balance sheets that do not have to rely on debt are more stable, particularly when interest rates increase or economic conditions deteriorate. They also tend to outperform when markets rally, in terms of delivering growth.
Using these three metrics, MSCI provides an overall quality ranking, and all securities are weighted by the product of their market cap weight in the parent index, and their quality score. Given the recognition of market cap weightings, institutional investors can use these ETFs as core holdings within the portfolio. With one simple trade, they can access a diversified set of well-established, cash-generative, unleveraged companies locked into a long-term growth trend.
Accessing winners across geographies
With U.S. quality a top-performing factor over the last four years, the BMO MSCI USA High Quality Index ETF (ZUQ) is a smart option for institutions that are seeking exposure to this high growth economy, through sectors like IT, healthcare and communications services. In particular, the tech sector in the U.S. has outperformed over the last year, with robust, established names including Alphabet, Microsoft, Facebook and Apple that have continued to demonstrate exceptional balance sheet strength.
Another ideal example of quality investing is the BMO MSCI Europe High Quality Hedged to CAD Index ETF (ZEQ). As the first quality strategy we launched in 2014, investors were interested in diversifying their equity exposure, but Europe was recovering from an economic crisis, so they wanted a path to invest in the region that offered more protection. The quality factor was an ideal solution, given the ongoing volatility in the area, the ETF continues to provide unbiased exposure to strong, growing European companies.
ZEQ is currently underweight financials, which have been higher risk in Europe than their counterparts in North America, while overweight in healthcare and industrials. Top holdings include Dutch multinational semiconductor supplier ASML and global pharmaceutical company Novo Nordisk, whose diabetes care products will still generate demand even if the economy is weak. As a result, it performed well in 2020, and the pharmaceutical giant has tremendous competitive advantages because it is leading the path on new diabetic treatments. Add to this a strong balance sheet, top ESG standards and the benefits of an ever-growing market, it offers both growth potential and downside protection if markets decline.
Meanwhile, for institutions seeking a one-ticket quality solution, BMO MSCI All Country World High Quality Index ETF (ZGQ) applies the same MSCI criteria to both the developed and emerging market universe, with the benefit of local currency appreciation.
Historically, factor investing has proven to be additive for institutional investors in terms of a risk-return framework, and the quality trade is no different. As a long-term hold, it acts consistently as an efficient core to a well-rounded, resilient portfolio – and a strong opportunity to improve risk-adjusted returns, particularly now as markets are gravitating back to their defensive comfort zones. To implement this factor, BMO’s suite of Quality ETFs provides a cost-effective, liquid and tax-efficient solution for institutions to gain exposure to global leaders positioned for long-term growth.
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