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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
    Simon
    Lansdorp
    PhD, 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.”

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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.”

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