Do you have enough QUALITY in your portfolio?
Factor investing aims to target quantifiable metrics that can explain differences in security returns.
At a high level, these factors are broadly influenced by general macroeconomic conditions such that there are times when we expect them to drive better returns in portfolios.
Notably, there is no universal definition for factors or even what metrics should be used to construct the factors, but for perspective, Morgan Stanley’s framework is shown in Exhibit 1. Furthermore, it is not possible to capture everything that can influence a factor simply with financial metrics. For example, the Quality factor can encompass companies with a durable competitive advantage in the form of a strong brand, a patented product or specialised manufacturing capabilities.
Exhibit 1 – Morgan Stanley’s Factor Framework
Source: Morgan Stanley Research, Morgan Stanley Wealth Management Research
Morgan Stanley believes now is the time to be increasing the Quality factor exposure in portfolios for the following reasons.
#1 – The US economic cycle is about to shift to the next stage
As noted by our Chief Investment Officer Lisa Shalett, Morgan Stanley’s economists estimate the recovery from the Global Covid Recession may rank among the fastest on record in terms of repair to business and consumer confidence, employment as well as investment. Morgan Stanley’s US cycle indicator is nearing the boundary of the Recovery phase of this economic cycle (see Exhibit 2). This means economic growth should begin to moderate and signals a need to reposition portfolios. As noted by Andrew Sheets, Morgan Stanley’s Global Cross-Asset Strategist, the complex confluence of early cycle timing, mid-cycle macro conditions and late-cycle valuations brings the Quality factor into focus. We believe investors will seek sources of what is believed to be dependable, stable returns amid increasing uncertainty as the cycle matures.
Exhibit 2 – Morgan Stanley’s US Cycle Indicator
Source: Morgan Stanley Research, Morgan Stanley Wealth Management GIC. Data as of 11 June 2021.
#2 – Quality is key based on current elevated valuations
Morgan Stanley’s recent Australian analysis reinforced the view that the Quality factor typically does well in the late part of the economic cycle, not the early to mid-cycle (see Australia Quantitative Strategy: Factor Views in 4D, 23 March 2021). However currently there is the issue that market valuations are well above long term averages and are essentially reflecting late-cycle economic conditions. Therefore, Quality investing can effectively be viewed as a hedge against unattractive relatively high valuations given the risk/return trade-off skews increasingly in an unfavourable fashion.
#3 – Tapering by the US Federal Reserve is a key risk and Quality should serve as a hedge
Given the current high valuations in equity markets there is the risk associated with the timing of the US Federal Reserve’s tapering and ultimately monetary tightening policies. There is currently significant debate in the market on the likely speed and strength of this recovery such that any tightening bias indicated by the Fed to date has led to bouts of elevated volatility. Morgan Stanley believes the Fed is gearing up to have a robust discussion regarding the approach to tapering at the July FOMC meeting with forward guidance provided at the September FOMC meeting. This is expected to be followed by an official announcement at the March meeting. The first interest rate increase to the Fed Fund Rate is expected in September 2023. Quality investing should serve as a hedge against the outcomes from these key upcoming events.
However in Australia, it is important to note that Quality investing is more nuanced than in key international markets. Contrary to offshore markets, it is difficult to find a pure domestic Quality ETF or fund that satisfies our Quality criteria domestically. In Australia, investors need to invest in either direct stocks or sectors. Morgan Stanley’s Australian equity strategy team finds that when using a factor lens, healthcare stocks in Australia tend to have a higher quality exposure, particularly in contrast to the technology sector. Interestingly, and contrary to historical global sensitivities, Australian banks' quality signals are improving through a stronger earnings and dividend pulse – although overall Australian banks remain a Value sector.
Within our model portfolios, we have implemented the Quality factor for our international equities’ allocation through the following ETFs:
VanEck Vectors MSCI World ex-Australia Quality ETF (ASX: QUAL)
QUAL aims to target quality growth stocks based on a quality score determined by three key factors: high return on equity, stable year-on-year earnings growth, and low financial leverage. We selected QUAL for our Focus List given the ETF’s robust smart beta index construction process. QUAL's quality index also has the longest and best-performing track record compared to peers. QUAL has a low tracking error against its underlying index, demonstrating it delivers on its targeted exposure. The ETF has ~$2 billion in assets held within the strategy.
Exhibit 3 – QUAL versus MSCI World ex-Australia Index
Source: Bloomberg, Morgan Stanley Wealth Management Research. Rebased to 100. From 22 June 2018 to 24 June 2021.
VanEck Vectors Morningstar Wide Moat ETF (ASX: MOAT)
MOAT is an actively managed concentrated portfolio of US companies with a “wide moat” as selected by Morningstar analysts. A “wide moat” is defined as a company having a sustainable competitive advantage after considering such factors as: intangible assets, switching cost, network effect, cost advantage and scale. We selected MOAT for our Focus List as its smart beta methodology blends the Quality factor with the Value factor, another desirable factor exposure at this point in the economic cycle. The ETF is equally weighted removing the size bias often found in the broader US market indices and is well established with ~$290 million in assets held within the strategy.
Exhibit 4 – MOAT versus S&P 500 Index
Source: Bloomberg, Morgan Stanley Wealth Management Research. Rebased to 100. From 22 June 2018 to 24 June 2021.
Capital Group New Perspective Fund (APIR: CIM0006AU, Hedged APIR: CIM0008AU)
The Capital Group New Perspective Fund invests in global companies best placed to benefit from changes in international trade patterns, economic trends and political relationships. The fund is on our Focus List because of its exceptionally well-resourced research efforts, robust risk management and long track record of outperformance. In addition, our style sensitivity analysis shows the fund has a strong Growth and Quality factor bias as well as some defensive qualities.
Exhibit 5 – Capital Group New Perspective Fund Factor Sensitivity Analysis
Fund average 12 month excess returns when…
Outperforms/Underperforms defined as +/- 1.0% or greater relative performance of equity style factor. Returns shown are net of manager and performance fees as of 31 May 2021. Fund: Capital Group New Perspective in AUD. Benchmark: MSCI ACWI Net Total Return AUD Index. Factor indices are subsets of the MSCI World Net Total Return Local Index. Source: Morgan Stanley Wealth Management Research, Bloomberg.
Fairlight Global Small & Mid Cap (SMID) Fund Class A (APIR: PIM7802AU, Hedged APIR: PIM0941AU)
The Fairlight Global Small & Mid Cap Fund invests in a portfolio of 30 to 40 global small and mid-capitalisation companies drawn from international equity markets using a concentrated, long only strategy, grounded in fundamental research with a strong focus on quality. The fund is on our Focus List because of the investment team’s specialised focus on global SMID stocks, the robust research process and proprietary models - all of which ensure consistency and alignment with the quality-focused philosophy. In addition, our style sensitivity analysis shows the fund has strong Growth and Quality factor biases.
Exhibit 6 – Fairlight Global Small & Mid Cap Fund Factor Sensitivity Analysis
Fund average 12 month excess returns when…
Outperforms/Underperforms defined as +/- 1.0% or greater relative performance of the sector. Returns shown are net of manager and performance fees as of 31 May 2021. Fund: Fairlight Global Small & Mid Cap. Benchmark: MSCI World SMID NR AUD. Sector indices are subsets of the MSCI World Ex Australia Net Total Return Local Index. Source: Morgan Stanley Wealth Management Research, Bloomberg, Morningstar, Fairlight Asset Management.
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