An Evolving Quality ETF

The quality factor, though often overlooked, is one of the five primary investment factors. Exchange traded funds can help investors focus directly on quality and some of those funds are evolving.

The Invesco S&P 500 Quality ETF SPHQ is over 13 years old, but the fund looks different today than it did when it debuted in late 2005.

What Happened

Today, SPHQ follows the S&P 500 Quality Index, a collection of 100 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 Invesco.

The S&P 500 Quality Index is not SPHQ's original index.

“Prior to June 30, 2010, the fund did not have a quality mandate,” said Morningstar in a recent note. “On that date it switched to the S&P 500 High Quality Rankings Index following a period of poor performance. It switched again in March 2016 to the S&P 500 Quality Index, which applies a more-transparent quantitative methodology. Invesco cited this transparency as the reason for the change. Because of these changes, the fund does not have a long record tracking its current benchmark.”

Why It's Important

Quality and its related characteristics are not limited to a specific sector, but in recent years, some sectors have seen increases in the number of components meeting the quality factor's standards. That scenario leads to some sector concentration risk in quality ETFs, including SPHQ.

Technology and health care, home to some of the strongest balance sheets in corporate America, combine for over half SPHQ's weight and the ETF is noticeably overweight technology relative to the S&P 500. However, there are benefits to overweighting quality.

“Firms that are more profitable and score well on other measures of quality have historically offered higher returns than their less-profitable and lower-quality counterparts,” according to Morningstar.

What's Next

While SPHQ allocates more than 37 percent of its weight to large-cap growth stocks, investors should not expect the fund to perform like a growth a fund.

“The types of quality stocks that the fund targets are unlikely to offer eye-popping returns, and they could lag the market for extended periods, particularly during strong market rallies,” said Morningstar. “So, they are probably not attractive to aggressive investors, which could cause them to become undervalued. These stocks should reward patient investors with a better risk/reward profile than the broader market over the long term.”

Morningstar upgraded SPHQ to a Silver rating from Bronze.

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