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Factor investing: defining quality

Factor investing: defining quality

11-07-2016 | Research

Robeco has added Quality to the key list of factors that it follows when constructing factor investing portfolios in equities. But how to define it? There is a disconnect between definitions of the factor ‘quality’ by academics and how it is defined by many in the asset management industry.

This could lead to confusion by investors who want to follow Quality along with the three other common factors used in equity investing: Value, Momentum and Low-Volatility. In a new white paper, four of Robeco’s quantitative investing experts provide an overview of common definitions and the differences between them.

“We show that there is a large dispersion in the definitions that are used for the quality factor with ‘industry’ definitions ranging from return-on-equity and profit margins to leverage and earnings variability, and ‘academic’ definitions such as operating accruals, net stock issues, and gross profitability,” say the report’s authors, Georgi Kyosev, Matthias X. Hanauer, Joop Huij and Simon Lansdorp.

“We document large performance differences between the different quality definitions. While ‘academic’ definitions for quality all seem to have significant predictive power for stock returns above and beyond common factors, we do not find significant predictive power for individual ‘industry’ definitions. Our results have important implications for the design of investment vehicles that provide investors exposure to the quality factor.”

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