No two factor indices are the same, and it pays to understand exactly how index methodology affects an underlying portfolio. Here, the Fidelity ETF team reveals the benefits of exposure to income and quality factors and how portfolio construction can help mitigate unintended by-products of this exposure
Factors such as size, value, quality, momentum, dividend yield and low volatility have been widely adopted by investors seeking higher returns, lower risk, better diversification or a combination of the three. A number of smart beta indices have been designed to offer a convenient way to get exposure to these factors.
One of the most popular factors remains quality and income. In theory, using a quality screen in tandem with an income screen should help reduce the volatility of the income factor by avoiding those companies with weak fundamentals that look attractive on a yield basis but will be unable to sustain dividends in the future, while still giving exposure to the high-quality, high yielding stocks.
And this is exactly what our quality-income backtests show: compared to the income screen on its own, the top quintile portfolio of a combination of the quality with income factors causes a significant drop in average annual volatility and a substantial improvement in Sharpe ratio. And the good news for income investors is that, although not as high as the income factor on its own, dividend yield is nearly twice that of the benchmark.
But why and when does the quality-income combination perform best?
By their nature, these factors tend to favour more mature, stable companies, and thus the quality-income combination offers significant outperformance over time. This outperformance and defensive tilt can provide a strategy that beats the market in the long run and offer protection in falling markets too. A valuable combination for today's markets.
The Fidelity Global Quality Income Index uses these two factors but features a more refined portfolio construction process to enhance the benefits and reduce the unintended exposures
To gain exclusive insight into the starting universe for the Fidelity Global Quality Income Index and how the group is building a range of ‘smarter' ETF strategies, download The ETF Evolution magazine for free here.