What do Amazon and Tesla have in common? They don't meet the MSCI's definition of a 'quality growth company'.

The MSCI World ex Australia Quality index, tracked by ETF provider VanEck in its International Quality ETF (ASX: QUAL), features companies across twenty-two developed markets that meet a quality screen.

But what is 'quality', and how do quality indexes differ from all world stock indexes?

Today, we dive into Silver-rated VanEck's QUAL and look at how companies are selected, what companies make the cut and how it differs from a broader global equity index.

How is a ‘quality’ index built?

QUAL is a narrower version of global equity ETFs such as Vanguard’s popular International Shares (ASX: VGS). It’s a “strategic beta” fund, meaning it takes a broad index and filters it according to criteria that can include quality, dividends or low volatility.

The foundation of QUAL is the MSCI World ex-Australia Index. It’s a widely used collection of almost 1500 large-and mid-cap stocks from 22 developed countries.

 

Next, each company is scored on three metrics:

  • Financial leverage – a measure of how much debt a company has relative to its equity
  • Return on equity—a measure of how profitably a company uses its assets
  • Sustainable earnings growth—a measure of how smoothly a company grows profits

The top 300 make up the MSCI World ex-Australia Quality Index, which QUAL fully replicates.

The logic behind a quality screen is to find growth businesses that reliably make money and are less susceptible to ups and downs in the economy. The hope is they have a competitive edge, says Morningstar senior manager research analyst Kongkon Gogoi.

“Stocks with quality traits are more resilient during distressed markets and elevated volatility conditions, which leads to outperformance,” he says.

More tech, fewer banks and lots of mega-caps

QUAL has more healthcare and IT stocks and fewer banks when compared to the average large cap blended global equity fund, although Gogoi thinks it’s a combination that can work for many Australian investors.

Banks are underrepresented because their leveraged balance sheets don’t always meet the quality screen around debt, he says.

A tenth of QUAL is tied up in financial stocks, versus 14.6% for large-cap global equity funds. For example, banking giants JPMorgan Chase (JPM) and Bank of America (BAC) don’t make the cut.

That’s not a bad thing because Australian investors are often already heavily exposed to finance on the ASX, says Gogoi. Banks make up roughly a third of the S&P/ASX 200.

QUAL’s screens also exclude many makers of consumer goods and energy companies when compared to the broader MSCI World ex-Australia. Gone are Doritos-maker PepsiCo (PEP), The Home Depot (HD) and Procter & Gamble (PG). Exxon-Mobil (XOM) is also absent.

In exchange, QUAL has lots of technology companies. They make up a third of the fund, almost double the 18% average for broader global equity funds.

And it’s a more concentrated set of firms. The top five holdings are Microsoft (MSFT), Apple (AAPL), Facebook (FB), chip-maker Nvidia (NVDA) and Alphabet (GOOGL). They make up 21.3% of the fund. The equivalent five holdings take up 13.2% of VGS.

This gives QUAL a heavy tilt to the US, but Gogoi says it’s more geographically diversified than it appears because these US mega-caps earn roughly 40% of their revenues elsewhere.

Companies absent from QUAL aren’t necessarily low quality, they just didn’t score in the top 300 of the 1500 odd stocks on MSCI World-ex Australia, says Russel Chesler, head of investments at VanEck.

“The quality screen is relative to everyone else. So, stock 301 might not have anything wrong with it but the overall score is not as high,” he says.

A company like Amazon (AMZN) is a household name but it has debt-to-equity ratio of 90% versus only 11% for Alphabet in FY 2020. That could have lowered its score for financial leverage, says Chesler.

Similarly, Tesla’s (TSLA) 6.7% return on equity in FY 2020 is short of Microsoft’s 42% and Apple at 72%.

Does quality outperform?

When the broader market declined by 12.8% in February and March 2020, QUAL fell by 7.5%.

Performance has also been strong in 'normal' times. QUAL’s three-year annualised return is 17.8%, versus 13.3% for the broader MSCI World ex-Australia Index.

Over the last five years, QUAL returned 18.67% (annualised), versus 15.18% for the broader index.

Chesler says that strong performance during drawdowns can sometimes lead quality screens to underperform in “frothy growth environments” where companies are highly leveraged.

“As with everything there are times when it can underperform,” he says.

Between 2004 and 2006, the fund underperformed the MSCI World ex-Australia, according to Chesler.

At 0.4% annual fees, QUAL is on the pricier end of passive ETFs. It’s almost double the 0.18% that VGS charges, although it’s cheaper than the average active manager says Gogoi.

Because the ETF invests with a specific factor in mind—quality growth—it should play a supporting role in a portfolio, says Gogoi. Investors should consider pairing it with other ETFs that have complementary styles such as blended or value.