In the field of factor investing, quality is undoubtedly the equity factor with the weakest consensus. This research investigates the best way to define it. In order to capture the multi-faceted reality of the factor depicted in academia, we address the quality factor through a multidimensional process by defining four self-reliant pillars: profitability, earnings quality, safety and investment. To better fit institutional investor’s’ needs, we analyze the resulting factor by focusing on the last eighteen years and on a global developed markets universe of liquid stocks (largeand mid-caps).
In a long-short framework, our quality factor delivers a statistically significant alpha that cannot be explained by loadings on conventional equity factors (market, value, size and momentum). Most regions and dimensions display positive contribution to this alpha, with the noticeable exceptions of the Eurozone region and the safety dimension. In a long-only framework, our quality factor outperforms its benchmark by 2.8% per annum over the entire analysis period, with an information ratio of 0.81. Furthermore, the outperformance has been very consistent since the 2008 Global Financial Crisis (GFC). The four dimensions are weakly correlated with each other and are therefore complementary. We show that safety is of particular importance during periods of market turmoil (GFC, Covid-19 pandemic) and that the dimension is therefore part of the quality factor in its own right. On the Eurozone side, a sector-neutral portfolio construction seems to be more suited.
We also introduce a new portfolio construction methodology by implementing a clustering approach based on the K-means algorithm to group together companies based on features that are related to both fundamentals and market characteristics. This approach allows to capture dynamic variations between fundamentals and other stock features. This fully implementable process results in better quality factor performance without impacting the associated risk measures or the portfolio’s quality exposure, as measured on the unconstrained quality factor.