Introducing a new factor – Quality

Introducing a new factor – Quality

05-12-2016 | Insight

Robeco has long been a pioneer in quantitative investing, having exploited the Value and Momentum effects since the early 1990s and Low Volatility since 2006. But we’re constantly looking for new factors to exploit. In 2013 we instigated a large-scale study that confirmed the existence of a fourth factor – Quality. Simon Lansdorp from our Factor Investing Research team explains the Quality effect and how we are now exploiting it.

  • Simon Lansdorp
    Portfolio Manager

What exactly is the quality effect?

“The quality effect is the tendency of high-quality stocks to outperform low-quality stocks and the market as a whole on a risk-adjusted basis. High-quality companies are typically considered to be highly profitable, have high earnings quality, and / or to be conservatively managed.”

Stay informed on Quant investing with monthly mail updates
Stay informed on Quant investing with monthly mail updates

How popular is quality among investors?

“The MSCI World Quality Index dates back to December 2012, and it has proven to be a popular index to track – there are already around USD 5 billion of assets in strategies following this index. We’ve seen demand for quality at Robeco as well, both on a standalone basis and in a multi-factor setting.’’

‘‘Multi-factor demand for quality can involve our clients asking us to add quality to the other three factors we exploit (value, momentum and low risk), while other investors have asked us to replace one of these three with quality.”

What’s the evidence that the quality factor adds value for investors?

“There’s strong evidence from long term data series covering various regions and various measures that the quality effect exists. Both asset managers and academics have long documented the existence of a quality premium. We’ve performed extensive empirical tests based on the performance of stocks in several international markets including Europe, the US, Japan and emerging markets over a period of over 25 years, and these have shown that the quality factor can add value not just as a standalone investment, but also as part of a multifactor solution.’’

‘‘Between June 1988 and December 2015, the MSCI World returned 7.3%, with a Sharpe ratio of 0.48. But according to our simulations, Robeco’s enhanced quality factor would have returned 12.3% with a Sharpe ratio of 0.92. Moreover, adding quality to a well-diversified multi-factor portfolio results in an improvement in its information ratio and lower tracking error and relative drawdowns.”

What are the explanations for the quality factor’s existence?

“There are two main theories – first that the quality effect is a result of investors’ reaction to risk, and second that it is due to mispricing. One of the risk-based explanations is that the higher risk-adjusted returns of quality stocks is consistent with the Efficient Market Hypothesis, so their outperformance represents compensation for some sort of risk factor that investors care about. This would imply that a quality strategy would be offensive in nature, with a high probability of crashing. However, empirical evidence shows that in fact quality is a defensive strategy that tends to outperform during bad times for the market.’’

“Conversely, an explanation based on mispricing is inconsistent with the Efficient Market Hypothesis and is related to investors’ behavior. This can either be rational, which can be linked to the nature of the institutional money management industry and how investors are incentivized, or irrational, such as when investors systematically fail to use all the information available.

At Robeco we find the mispricing explanation to be the more plausible, although more work is needed to pinpoint the source of the quality premium.”

What’s the history of quality at Robeco?

“Our research has shown that generic definitions of quality, such as growth in profitability or earnings growth, have weak, and sometimes even no, predictive power of future returns. Interestingly, definitions of quality used by academics generally outperform those commonly used in the asset management industry.”

How does Robeco define quality?

“Our research has shown that generic definitions of quality, such as growth in profitability or earnings growth, have weak, and sometimes even no, predictive power of future returns. Interestingly, definitions of quality used by academics generally outperform those commonly used in the asset management industry.”

‘‘Our definition of quality takes into account several variables including profitability, earnings quality and investments. Each of these themes has deeply rooted academic underpinnings and has been shown to produce strong standalone performance.”

Subjects related to this article are:

Disclaimer Robeco Switzerland Ltd.

The information contained on these pages is for marketing purposes and solely intended for Qualified Investors in accordance with the Swiss Collective Investment Schemes Act of 23 June 2006 (“CISA”) domiciled in Switzerland, Professional Clients in accordance with Annex II of the Markets in Financial Instruments Directive II (“MiFID II”) domiciled in the European Union und European Economic Area with a license to distribute / promote financial instruments in such capacity or herewith requesting respective information on products and services in their capacity as Professional Clients. 

The Funds are domiciled in Luxembourg and The Netherlands. ACOLIN Fund Services AG, postal address: Affolternstrasse 56, 8050 Zürich, acts as the Swiss representative of the Fund(s). UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zurich, postal address: Europastrasse 2, P.O. Box, CH-8152 Opfikon, acts as the Swiss paying agent. The prospectus, the Key Investor Information Documents (KIIDs), the articles of association, the annual and semi-annual reports of the Fund(s) may be obtained, on simple request and free of charge, at the office of the Swiss representative ACOLIN Fund Services AG. The prospectuses are also available via the website www.robeco.ch. Some funds about which information is shown on these pages may fall outside the scope of the Swiss Collective Investment Schemes Act of 26 June 2006 (“CISA”) and therefore do not (need to) have a license from or registration with the Swiss Financial Market Supervisory Authority (FINMA). 

Some funds about which information is shown on this website may not be available in your domicile country. Please check the registration status in your respective domicile country. To view the RobecoSwitzerland Ltd. products that are registered/available in your country, please go to the respective Fund Selector, which can be found on this website and select your country of domicile. 

Neither information nor any opinion expressed on this website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. An investment in a Robeco Switzerland Ltd. product should only be made after reading the related legal documents such as management regulations, prospectuses, annual and semi-annual reports. 

By clicking “I agree” you confirm that you/the company you represent falls under one of the above-mentioned categories of addressees and that you have read, understood and accept the terms of use for this website.

I Disagree