Getting To The Cause Of Quality

Among the hot “smart beta” strategies into which investors are pouring assets is quality. For example, the iShares Edge MSCI USA Quality Factor ETF (QUAL | A-84), which is only about three years old, already has $2.7 billion in assets. Before you consider investing in these increasingly popular strategies, however, it’s worth understanding the sources of their returns. That, in turn, raises an important question: Is the quality factor risk-based, or is it a behavioral anomaly?

Robert Novy-Marx’s 2012 paper, “The Other Side of Value: The Gross Profitability Premium,” provided investors with new insights into the cross section of stock returns. His study built upon the 2007study “Profitability, Investment and Average Returns” by Eugene Fama and Kenneth French, who had shown that firms with high profitability measured by earnings have high subsequent returns after controlling for book-to-market ratio and investment.

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