Seeking quality in the S&P 500

This fund favours highly profitable firms with durable competitive advantages.

Alex Bryan 27 June, 2017 | 5:00PM

 PowerShares S&P 500 Quality ETF (SPHQ) did not always have a quality mandate. Prior to June 30, 2010, it tracked the Value Line Timeliness Select Index, which did not behave anything like a quality strategy. But because of poor performance, PowerShares moved the exchange-traded fund over to the S&P 500 High Quality Rankings Index on that date. That move wasn't great from a stewardship perspective (it would have been better for the firm to shutter the original fund), and it rendered much of the fund's performance irrelevant. It switched benchmarks again in March 2016 to the S&P 500 Quality Index, which applies a more transparent quantitative methodology.

The fund targets 100 stocks from the S&P 500 with the strongest quality characteristics. It measures quality based on high return on equity (a measure of profitability), low financial leverage, and low growth in net operating assets during the most recent year. Stocks that make the cut are weighted according to both the strength of their quality characteristics and their market capitalization. But the portfolio caps each stock's weighting at 5%. The fund's index applies a buffer rule to mitigate unnecessary turnover, which should help reduce transaction costs. It reconstitutes semi-annually in June and December.

This benchmark is well-crafted and, if the fund sticks with it, this strategy should hold up better than most of its peers during market downturns and offer attractive performance over a full market cycle. However, there is a cheaper alternative that better diversifies sector risk:  iShares Edge MSCI USA Quality Factor (QUAL) targets stocks with strong quality characteristics relative to their sector peers, then matches its sector weightings to those of the broad, market-cap-weighted MSCI USA Index to help investors avoid unintended sector bets. This sector-relative approach improves comparability but can also cause the fund to own some names with lower absolute quality characteristics than it otherwise would. Similar to SPHQ, it weights its holdings according to both the strength of their quality characteristics and their market capitalization.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
PepsiCo Inc145.85 USD0.48
Procter & Gamble Co126.70 USD0.09
Stryker Corp224.30 USD-0.08

About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.