Momentum, growth, and value factors, among others, all suffered in March. But one factor performed particularly well: quality.
What is the Quality Factor and Why Does it Matter?
Quality refers to the tendency of high-quality stocks to outperform low-quality stocks over time. The former tends to have more stable earnings, stronger balance sheets and higher margins than the latter. Given the factor’s defensive nature, many consider quality to be a safe haven during volatile times.
How do we proxy quality? We believe the Dow Jones U.S. Thematic Market Neutral Quality Index (ticker: DJTMNQU) is one of the better gauges. This index is designed to measure the performance of a long/short strategy utilizing a long position in high-quality companies and a short position in low-quality companies. How did it do in March? DJTMNQU was up +11.9% while the S&P 500 was down -12.4%.
Additionally, quality is associated with larger cap stocks, contributing to recent outperformance. In March, the S&P 500 was down -12.4%, while the Russell 2000 was down -21.9%. Essentially, nearly 10 percentage points separated market cap-weighted returns.
The statistical outperformance of quality confirms what we are hearing directly from hedge fund managers. Managers outperforming this year tell us that they dumped stocks with high leverage and rotated into those with better balance sheets (i.e., with less debt) at the end of February and beginning of March, as they became increasingly concerned about the global spread of the coronavirus. These PMs examined their portfolios and calculated exposure to companies with liquidity issues or business models highly dependent on travel – and they reduced exposures accordingly.
What are the Right Questions to Ask?
On the long side, managers have been “high-grading” into larger cap, growth companies with enough cash to sustain them throughout 2020. On the short side, they have been adding highly leveraged companies with limited cash and with business models that have been significantly impacted by the economic shutdown caused by the coronavirus.
During your remote managers meetings, we recommend asking the following:
What role does quality play in your investment approach?
Will you need to reposition your portfolio again out of higher quality and into lower quality as the recovery takes shape?
How are you balancing this in your portfolio with the market volatility?
Why Does Quality Matter Now?
Typically, quality leads in a bear market but lags in a bull market. So, timing is an important consideration. To terribly misrepresent a quote from the The Dark Knight, quality factor outperformance is not what Gotham needs right now, but it’s what we have. We will hunt it, we will take it.