Analysis: The Quality Factor by Time Horizon

Jul 8, 2019 | Factor Investment

In the previous two blogs we looked at Quality from a high level and from a sector perspective. In this entry, we are looking at Quality from a time horizon.

As a refresher, for this demonstration we constructed a portfolio based on three key sub-factors: profit, growth and safety. To test the performance of our quality portfolio, we back tested the ten portfolios over the period January 1, 2010 to April 30, 2019. The portfolio was rebalanced quarterly using a market-cap weighted method, with 20 basis points deducted as costs per transaction.

Like the last two blog entries, we provide information on both individual and composite Quality Factors.

Below is a heat map demonstrating the yearly return based on the Quality individual and composite factors.

Yearly returns by sub-factors

What’s interesting about this heatmap is that it clearly shows that the different sub-factors of the quality factor drove outperformance at different times.

For example, in 2013 and 2017, the two best years for the S&P 500 over the period, the Quality_Growth portfolio was the best performing portfolio of the three sub-factor portfolios. However, the results were very different in the years in which the S&P 500 generated low or negative returns. This suggests that investors gravitated towards high quality stocks that were regarded as safe. Then, in 2018, a year in which global equity markets fell sharply on the back of trade war uncertainty and the S&P 500 finished 5% lower for the year, it was the Quality_Profit portfolio that outperformed. In this scenario, investors focused on high quality companies with stable profits.

The takeaway here is that the different components of a quality strategy are likely to drive outperformance at different times. When investors are bullish, they will focus more on growth. However, during periods of uncertainty, they are more likely to focus on stocks that offer safety and reliable profits.

Being able to look at the Quality Factors through different lenses like time horizons is a strength of Kavout: our specialty lies not only in the breadth and depth of data, but also the ability to offer new perspectives and slice-and-dice the information according to your needs. By doing this, we are not trying to replace the human investor – we strive to make the human investor better.

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