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what is the quality factor for quantitative equity portfolio investing
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STRATxAI

February 2024 · 5 min read

Quality Factor

Educational
Intermediate

What is the quality factor ?

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

  • strong balance sheets
  • robust earnings growth and cost-efficiency metrics
  • have good governance and management

The quality factor therefore represents company strength and is illustrative of well-managed businesses.

Categories of quality

Considering ways to measure a companies quality, we can classify companies under some broad quality categories

Broad quality categories to rank companies by.

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

  1. the safety category containing metrics that represent company leverage, bankruptcy risk or idiosyncratic beta or volatility.
  2. A growth category may contain earnings growth metrics and/or earnings volatility metrics.
  3. The profitability category can store items such as gross margin, return-on-equity, cashflow metrics.

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.

Illustration of the quality effect

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%.

Volatility of the long-short Fama-French quality factor
The rolling 1-year volatility of the quality factor compared to other style Fama-French style factors. Value (hml) and momentum, especially since covid pandemic in 2020, have structurally higher volatility than quality.
Correlation of the quality factor to other style factors

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.

Correlation of the long-short quality factor to other Fama-French style factors such as value (hml), size(smb) and momentum (mom)
Correlation of the long-short quality factor to other Fama-French style factors such as value (hml), size(smb) and momentum (mom), based on a 2 year lookback window

It is nice to see that the correlation graphs align with our thinking in terms of, quality being negatively correlated with size and value.

In what periods does quality do well ?

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.

Quality factor performance against other Fama-French style factors, time period 2010-2022
Quality factor performance against other Fama-French style factors, time period 2010-2022
Historical yearly path performance of the quality factor

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).

Quality factor yearly performance paths since 2010, long-short market neutral construction
Quality factor yearly performance paths since 2010, long-short market neutral construction. Black line with red dot is performance in 2022 so far.
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