With a slowing economy that may be heading towards a recession, quality stocks are becoming more favorable. Quality stocks have strong balance sheets, which means they have a low risk of default. This is particularly valuable during an economic slowdown. In such situations, the Federal Reserve typically stops raising interest rates, and historically, quality stocks have outperformed in this rate environment. Quality, along with growth, is considered to be the best-performing equity factor. On the other hand, the performance of value and small-cap stocks is not as impressive due to rising interest rates. However, the recent drop in interest rates has provided a tailwind for value and small-cap stocks.
The Vanguard U.S. Quality Factor ETF (VFQY) is a quality ETF with a strong tilt towards value and small-cap stocks. This tilt makes VFQY an interesting choice compared to other quality ETFs. Over the past 12 months, the best-performing quality ETFs have been the iShares MSCI USA Quality Factor ETF (QUAL) and the JPMorgan U.S. Quality Factor ETF (JQUA), which have a more defensive approach. The Wahed FTSE USA Shariah ETF (HLAL) has also performed well. The only quality ETF that has not outperformed the S&P 500 is VFQY. However, over the past month, VFQY has been the best-performing quality ETF thanks to its value and small-cap tilt.
It is uncertain whether this trend will continue. The Vanguard U.S. Quality Factor ETF is benchmarked to the Russell 3000 Index, which represents approximately 98% of the investable U.S. equity market. This gives VFQY a small-cap tilt. In comparison, the iShares MSCI USA Quality Factor ETF is benchmarked to the MSCI USA Sector Neutral Quality Index and does not take any sector bets compared to the S&P 500. VFQY’s small-cap and value tilt moves it away from being classified as large-cap growth, resulting in a more balanced profile for value/growth and size.
VFQY’s factor betas for size and value are currently even higher than the quality factor beta. On the other hand, QUAL is a pure quality ETF, with factor betas for value, size, low volatility, and momentum close to zero. VFQY has a cheap valuation, with a P/E ratio of less than 15. It is surprising that VFQY’s return on equity is lower than the Russell 3000, considering its focus on return on equity in its rules-based quantitative model. The top sectors for VFQY are Technology, Industrials, Financials, and Consumer Discretionary, while QUAL is underweight in Technology and Communication Services and overweight in Industrials and Financials.
VFQY is better diversified than QUAL, with less than 15% of its holdings in the top 10 compared to QUAL’s almost 40%. The small-cap and value tilt of VFQY makes it an interesting choice over other quality ETFs. Small caps have been underperforming due to their weaker balance sheets and higher interest expenses. However, if the Federal Reserve starts cutting rates or if there is a soft landing without a recession, this will benefit small caps. Lower long-term interest rates have already had a positive impact on small-cap performance. Small caps are also inexpensive, which could provide further tailwinds.
Value stocks, like small caps, have been underperforming compared to growth stocks, especially in the US. Outside the US, where the AI boom is less pronounced, value stocks are performing better. Value stocks are also relatively cheap compared to growth stocks. Quality stocks, on the other hand, have been in a strong long-term uptrend. The situation for value and size stocks is improving, although value stocks are not yet in a clear uptrend. All quality ETFs are currently in a long-term uptrend, with QUAL and VFQY having the highest scores.
In conclusion, while it is uncertain whether we are already in a recession, the Federal Reserve’s rate hikes are certainly slowing down the economy. Quality stocks tend to outperform when the Fed stops raising interest rates and the economy slows down or enters a recession. With long-term interest rates decreasing, value and small-cap stocks are benefiting, which is a tailwind for VFQY. Overall, we remain positive about quality stocks, especially QUAL, but VFQY provides a nice complement and diversification to a quality stock allocation.
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