Flat Illustration concept customer rating on tablets

No matter how rigorous and time-tested, no investment process can escape unscathed from the ravages of a market meltdown. So it was in a maddening March, when the 11-year-old bull market became one of the early casualties of Covid-19.

“There’s definitely some indiscriminate selling going on right now in the market,” says Peter Tomiuk, senior vice president, ETF strategy, with CI First Asset, a division of Toronto-based CI Investments Inc.

As money managers, financial advisors and individual investors survey the recent disastrous losses, the question becomes: What types of companies are better able to withstand a looming global recession and are well positioned to recover during the next market cycle?

Among factor-based ETFs listed in Canada, the more familiar are those that employ value, growth or low-volatility criteria. Less well known, but perhaps deserving of more attention in today’s volatile investment climate, are ETFs that employ quality factors. Though methodologies differ somewhat among fund managers, common elements of quality are measures of profitability, earnings consistency and balance sheet strength.

“Quality has been one of the best performing factors over the past four to five years. It’s a factor that maybe hasn’t resonated as much with investors because it’s kind of a newer factor,” says Chris Heakes, director and portfolio manager, ETFs, with Toronto-based BMO Asset Management Inc. (BMOAM). Launched in 2014, the BMO ETFs have the longest track records of any ETFs specifically dedicated to quality factors.

With funds in the global, U.S. and European equity categories, BMO is one of three Canadian providers whose quality-factor ETFs employ MSCI indexes. The MSCI strategies are based on three fundamental characteristics: high return on equity, stable year-over-year earnings growth and low financial leverage. The stock weightings in the BMO and CI First Asset ETFs are derived from a combination of the MSCI quality scores and market capitalization.

“Quality is really about identifying the best companies in the world,” says Heakes, adding that they could be either growth or value companies. “I think of it as like almost a Warren-Buffett style of investing where you’re looking for companies that have some kind of competitive advantage and that are really successful [in] their respective industries.”

The BMO ETFs are broadly diversified in terms of number of holdings. At the end of February, the U.S. and Europe ETFs each held 125 names, while the global ETF held 329. The maximum weighting per stock at the semi-annual rebalancing is capped at 5%.

“We like to have that diversification; I think that’s part of what makes most ETFs attractive for end clients,” says Heakes. In the global and U.S. mandates, the largest recent sector weighting is information technology, with U.S.-based mega-caps Microsoft Corp. and Apple Inc. the top holdings. In the European ETF it’s health care, led by Swiss-based Roche Holding AG.

In the Canadian equity category is CI First Asset MSCI Canada Quality Index Class ETF, offered since 2016. It holds a concentrated portfolio of 25 large and mid-cap stocks, with financial services the largest sector weighting. A newer MSCI-driven fund is iShares Edge MSCI USA Quality Factor Index ETF, offered by Toronto-based BlackRock Asset Management Canada Ltd. Launched in September 2019, it differs from its BMO U.S. equity rival because it employs sector-neutral weightings in line with the broad MSCI USA Index.

Other entrants in quality-factor investing include Toronto-based Fidelity Investments Canada ULC, whose year-old ETFs in the Canadian, U.S. and international categories are based on proprietary quality indexes developed by the Fidelity organization in the U.S. These strategies seek to identify companies with high and stable levels of profitability. For most industries, Fidelity employs three quality factors: free cash flow margin, return on invested capital and free cash flow stability. For the banking industry, there are two quality factors: return on equity and debt to assets.

Elsewhere, quality can form part of a multi-factor strategy. This is the case with the iShares Core MSCI suite of quality dividend ETFs, and the CI WisdomTree quality dividend growth ETFs. The latter employ two quality factors: three-year historical averages for return on equity, and return on assets.

“One element when it comes to companies that exhibit quality characteristics is consistent asset growth as well, along with return on equity,” Tomiuk says.

Among the multi-factor strategies is CI WisdomTree Canada Quality Dividend Growth Index ETF, which incorporates quality, dividends and growth. Tomiuk says the ETF can be considered more of a core Canadian equity solution for investors.

During the pre-crash periods ended Feb. 29, quality factor ETFs with at least three years of history were among the best performers in their respective categories. The three oldest — BMO MSCI All Country World High Quality Index ETF, BMO MSCI USA High Quality Index ETF and BMO MSCI Europe High Quality Hedged to CAD Index ETF — each had the top five-star Morningstar Rating for risk-adjusted returns. So did CI First Asset’s MSCI-based quality ETF.

“We’ve seen a lot of evidence that quality does provide reasonably stable returns,” says Tomiuk. “You tend to see a little bit more outperformance when you’re late cycle or when you’re in an economic slowdown, because investors are willing to pay a premium for quality and stability in those periods.”

In the wake of the bear market that began in March with multiple market plunges and extreme volatility, there’s no clear picture of how strategies will fare. But Heakes says companies that have a history of consistent profitability, strong free cash flow and low debt levels are better positioned to weather the coronavirus pandemic and global recession. Although quality hasn’t gained the recognition of some other factors, “it’s one that tends to serve investors pretty well.”

Quality strategies would tend to lag, says Heakes, in an environment that was a “somewhat indiscriminate” bull market where every stock rallies. “If you’re getting that big bounce-back when everyone’s just feeling good and pouring cash into assets, willing to take extra risk — perhaps willing to take too much risk — quality assets will still do well but they might have a little more measured growth profile.”

Needless to say, underperforming in an overheated market is the least of investors’ worries these days.