The quality factor is quite a subjective factor with no fixed definition. Quantitative signals vary in their implementation from an asset manager to a hedge fund.
The quality factor broadly represents companies that have
The quality factor therefore represents company strength and is illustrative of well-managed businesses.
Considering ways to measure a companies quality, we can classify companies under some broad quality categories
Each of the three categories contain various sub-factors that are measured via balance sheet ratios and derived metrics. This is not an exhaustive set and researchers have also proposed various other categories.
If we consider the listed categories above, we can imagine
A robust quantitative strategy can be then built by constructing and weighting all of the sub-factors within each category and then weighting the categories together to obtain a final investable quantitatively-driven strategy.
The idea behind this type of method is obviously to encapsulate a broad spectrum of quality sub-factors. By using this set of diverse sub-factors, it allows investors to then effectively rank all stocks in our universe, choosing the top 20 stocks for example. This allows an investor to obtain a well-balanced strategy that represents companies of the highest quality.
The quality factor, as shown in the graph below, tends to have a lower rolling volatility than other style factors.
On average the long-short quality factor has a 1y rolling volatility of less than 10%.
Due to the characteristics it possesses, the quality factor has more nuanced properties than some alternative style factors.
Other style factors such as size for example, can very easily be summarised as small market cap stocks earning a return premium over large cap stocks to compensate investors for taking on the larger risk small cap companies possess.
Additionally, momentum stocks being purely price-based can be summarised as recent winners continuing to outperform recent losers.
Quality on the other hand is concerned with more complicated balance sheet items where the relationship needs to be analysed on a deeper level and the easiest summary for quality is that it represents stronger/larger, well-managed companies with robust balance sheets and growth.
It is nice to see that the correlation graphs align with our thinking in terms of, quality being negatively correlated with size and value.
The performance chart below reviews the quality factor over the period 2010-2022. The quality factor has had quite an average decade with the only real performance coming after 2017. However, in more recent years we have seen quality correlate nicely with momentum to show strong performance.
What is noticeable, is that the volatility of quality is lower than that of the other style factors. Again, some of this we may first put down to the size of companies within quality and by hypothesising that large companies are less volatile. However, the quality factor here is market-neutral and so it is the quality factor premium we are modelling. The plot does show us that quality and size, due to their close links, are quite similar in terms of volatility. However, it is evident that value and momentum are more volatile. This also makes sense due to stock prices being involved in the construction of momentum and value, either directly or indirectly.
Next we plot the Fama-French quality factor yearly performance, where the factor is long-short market neutral based on profitability and investment sub-factors. So far in 2022, the quality factor has had a torrid time and has lived up to the reputation that quality is negatively associated with value (i.e value has had a great 2022 so far).