The quality factor is a characteristic that has been identified in the financial literature as potentially predictive of higher returns. It is often used in the context of factor investing, which is an investment strategy that involves selecting stocks based on certain attributes or characteristics that have been shown to be associated with higher returns.
The quality factor is typically defined as the combination of several financial measures that are thought to reflect the overall financial health and stability of a company. These measures may include things like profitability, earnings stability, and low financial leverage. Companies with high quality scores are generally considered to be more financially stable and less risky than those with lower scores.
Investors who employ a quality factor strategy may select stocks based on their quality scores, with the expectation that these stocks will outperform the broader market over the long term. Quality factor strategies are often used as part of a long-term, buy-and-hold approach, as they are based on the idea that high-quality companies are more likely to generate consistent returns over time.
Strong balance sheets, indicating financial stability and low risk
Robust earnings growth and cost-efficiency metrics, indicating a company's ability to generate profits and operate efficiently
Good governance and management, reflecting the company's leadership and decision-making processes
The quality factor can be broken down into several sub-categories, each of which includes various financial measures that reflect different aspects of a company's financial health. For example, the safety category may include measures of leverage, bankruptcy risk, and volatility, while the growth category may include metrics such as earnings growth and earnings volatility. The profitability category may include measures such as gross margin and return-on-equity.
To construct a quantitatively-driven quality factor strategy, an investor may combine and weight these sub-factors within each category, and then weight the categories together to form a final investable strategy. This allows the investor to rank all stocks in the universe based on their overall quality, and select a portfolio of the highest-quality stocks. The goal of this approach is to capture a diverse set of quality sub-factors and create a well-balanced portfolio of high-quality companies.
As demonstrated in the graph below, the quality factor typically exhibits lower volatility compared to other style factors. On average, the long-short quality factor has a 1-year rolling volatility of less than 10%. This suggests that investments in high-quality companies may be less prone to large price fluctuations over time, making them a potentially attractive option for investors seeking to manage risk in their portfolio.
The rolling 1-year volatility of the quality factor compared to other style Fama-French style factors. Value (hml) and momentum, especially since covid pandemic in 2020, have structurally higher volatility than quality.
Correlation of the quality factor to other style factors
Unlike some other style factors, the quality factor has more complex characteristics. For example, the size factor can be summarized as small-cap stocks earning a higher return than large-cap stocks due to the higher risk associated with small-cap companies. Similarly, the momentum factor can be summarized as recent winners continuing to outperform recent losers. In contrast, the quality factor is concerned with more detailed financial measures, such as balance sheet items, and can be summarized as representing strong, well-managed companies with robust balance sheets and growth potential. This requires a deeper analysis of the relationships between these factors in order to fully understand the quality factor.
Correlation of the long-short quality factor to other Fama-French style factors such as value (hml), size (smb) and momentum (mom), based on a 2 year lookback window
The quality factor has shown average performance over the past decade, with the strongest returns occurring after 2017. In recent years, the quality factor has had a positive correlation with the momentum factor, resulting in strong performance. It is also notable that the volatility of the quality factor is lower than that of other style factors, such as value and momentum. This may be due to the fact that large companies, which are often included in the quality factor, tend to be less volatile, as well as the market-neutral nature of the quality factor. The plot also suggests that the quality factor and size factor have similar levels of volatility, while value and momentum are more volatile due to their reliance on stock prices.
Quality factor performance against other Fama-French style factors, time period 2010-2022