Diversified exposure to quality U.S. stocks

This ETF offers a low-cost way to invest in profitable companies with durable competitive advantages.

Alex Bryan 15 September, 2015 | 5:00PM

Good companies don't always make good investments, but they may offer attractive returns relative to the market over the long term when they are trading at reasonable valuations, as they are now. Investors can get low-cost exposure to quality U.S. stocks through  iShares MSCI USA Quality Factor (QUAL) (0.15% expense ratio). This U.S.-traded ETF tracks an index that targets large- and mid-cap U.S. stocks with high returns on equity, low debt/capital ratios and low variability in earnings growth over the previous five years relative to their sector peers. It weights its holdings according to both the degree to which they exhibit these characteristics and their market capitalization. This skews the portfolio toward stocks with durable competitive advantages.

The types of stocks the fund owns have tended to hold up a little better than average during market downturns. Strong competitive advantages help protect profits and make these firms slightly less sensitive to the business cycle than less advantaged firms. However, they also can underperform for many years, particularly during strong market rallies. For instance, during the bear market from late 2007 to early 2009, the fund's index cumulatively lost 47%, while the MSCI USA Index lost 54.7%. However, it has trailed this benchmark by about 0.8 percentage points annualized since the market bottomed in March 2009. This fund launched in July 2013, so it doesn't have a long performance record. While the back-tested performance of its index looks good, there is a risk that it may not work as well out of sample.

That said, there is a compelling case for investing in stocks with durable competitive advantages and strong profitability, including their tendency to outperform in tough economic environments. In a recently published study titled Quality Minus Junk, Cliff Asness and several other principals at AQR found that stocks with high and growing profitability, high payout rates and low market volatility and fundamental risk historically outperformed their less advantaged counterparts.

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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.

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