Make The Quality Call With This ETF

Among investment factors, the growth, low volatility and value factors are capturing most of the headlines this year. Growth and value because the latter is trumping the former for the first time in several years. Low volatility because that factor is reigning supreme this year.

That does not mean the quality factor and the various exchange-traded funds dedicated to it should be overlooked. Hallmarks of the quality factor, one of the most venerable investment factors, include identifying companies that grow earnings at impressive clips, pay and raise dividends and generated prodigious amounts of free cash.

The Role Of Quality

Investors can access those positive traits with the PowerShares S&P 500 Hgh Qlty Prtfl (ETF) SPHQ. The $887.5 million SPHQ will celebrate its eleventh anniversary in December, making it one of the oldest quality ETFs on the market, but investors should note PowerShares recently changed SPHQ's underlying index to the S&P 500 Quality Index.

That index features S&P 500 members “that have the highest quality score, which is calculated based on three fundamental measures, return on equity, accruals ratio and financial leverage ratio,” according to PowerShares.

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Quality, Value And SPHQ's Allocations

SPHQ is also a case study in how the quality and value factors differ. For example, many value ETFs currently feature large combined allocations to the energy and financial services sectors. Conversely, SPHQ devotes barely more than three percent of its weight to those groups. Value ETFs also are not likely to have big weights to consumer discretionary names because that sector is seen as richly valued, but it is also SPHQ's largest sector allocation at 20.5 percent.

The energy's sector barely noticeable presence in SPHQ is understandable given the metrics the ETF uses to assess quality.

<>“SPHQ’s underlying index gauges profitability according to a company’s return on equity (ROE), which measures how much profit a company generates from invested capital. A high ROE implies that a company is managing its equity efficiently and profitably,” said PowerShares in a new note.

“Excessive use of debt can result in unstable cash flow and earnings – putting a firm at higher risk of defaulting on debt payments and other financial obligations. SPHQ’s underlying index considers a company’s financial leverage ratio – screening out firms that are making poor use of debt.”

Emphasizing those metrics might explain why SPHQ's underlying index is outpacing the S&P 500 by nearly 50 basis points this year. That and market turbulence earlier in the year.

“The goal of these rigorous screens is to find quality stocks with the potential to outperform lower-quality issues over long time horizons –particularly when markets become turbulent. Our high conviction in quality investing is based on the quality factor’s track record of performance. Since the inception of the S&P 500 Quality Index, quality stocks have outperformed low quality stocks during periods of heightened market volatility, as measured by rising VIX – a barometer of near-term volatility,” added PowerShares.