Quality isn’t what it used to be.
As a defensive quantitative factor, quality historically has provided a degree of risk management during stock market tumbles. But quality didn’t live up to its reputation during 2018’s fourth-quarter stock market sell-off.
Scott Opsal, director of research for The Leuthold Group, who also manages their factor tilt exchange-traded fund portfolio, was moving the firm’s holdings from a momentum tilt to a quality tilt last fall. He expected this defensive move would limit downside losses as the stock market wobbled, but it didn’t.
Wanting to understand why, he reviewed the fourth-quarter performance of two high-quality indexes: the S&P 500 Quality Index and MSCI Sector Neutral Quality Index. He found neither index beat its respective benchmark, the S&P 500 and the MSCI USA Index, not even during the depths of the sell-off when the S&P 500 fell 19.4 percent from its September peak. The S&P 500 ended 2018 down 6.3 percent.
He says some popular quality-focused ETFs did worse than the broader market in the fourth quarter. The iShares Core S&P 500 ETF (IVV) fell 13.5 percent, iShares Edge MSCI USA Quality Factor ETF (QUAL) lost 14.7 percent, Invesco S&P 500 Quality ETF (SPHQ) slid 14.8 percent, Invesco S&P SmallCap Quality ETF (XSHQ) dropped 17.1 percent and Vanguard U.S. Quality Factor ETF (VFQY) skidded 17.7 percent.
Quality is one of three defensive factors, along with low volatility and dividend growth. Momentum is considered a growth factor, and quality is often paired with it as a way to diversify an equity portfolio. However, last year’s sell-off threw “a wrench into the workings of portfolio diversification and downside protection,” Opsal wrote in a research note.
He told ETF Advisor that of the six main factors—quality, low volatility, size, dividends, momentum and value—quality was the worst performer in January with a loss of 8.3 percent. Low volatility did best, if one could call it that, with a 0.38 percent drop.
His research found the momentum and quality factors tracked closely throughout 2018, and except when the broader market began to top during the late summer, the correlation between quality and momentum held above 90 percent.
“The correlation nearly reached 100 percent in the December slump, leaving quality buyers wondering what happened to their diversified portfolios!” he wrote. “The old adage says that in a bear market, all correlations go to one. It appears that quality—and the other defensive factors—fell victim to this phenomenon in the fourth quarter.”
This is not to say none of the defensive factors work in down markets. Opsal used the S&P 500 Dividend Aristocrats Index to lump quality, low volatility and dividend growth in one package. Looking at monthly returns over the past 20 years, that index underperformed the S&P 500 53 percent of the time in up months, but outperformed 76 percent of the time during down months.