You may be wondering why anyone would ever want to hold a portfolio other than one focused on high quality. In fact, lower quality names benefited tremendously from the low inflation, low interest-rate environment of the post-Global Financial Crisis era. A surprise pivot from the Fed toward aggressive rate cuts poses a risk to the quality factor.
Seeking out higher quality names is particularly important for the small-cap asset class. The Russell 2000 Index of small cap companies today has nearly double the percentage of non-earners as the index’s long-term average, making the small cap asset class vulnerable to a period of sustained, high interest rates. Combining a quality screen with active management is our preferred approach to small cap equities.
Seeking out quality
Our quality bias is evident across client portfolios. In Portfolio Architect and our “outsourced CIO” portfolios, we utilize a mix of active and passive proprietary and external strategies to implement an overweight to quality across asset classes. As mentioned above, our tilt toward quality is most pronounced in the U.S. small-cap equity asset class, which worked well in 2022.
Our quantitatively oriented portfolios use a direct-indexing-like approach to isolate factors in U.S. large cap, and those portfolios also favor quality. The flexibility of this strategy also allows the profitability factor to be more heavily emphasized.
Screening for quality has long been a part of the process for our proprietary equity strategies, including the Enhanced Dividend Income, Dividend Growth, and Disciplined Core equity strategies. All three of these portfolios have a higher exposure to quality than their benchmarks, which contributed to solid outperformance in 2022.
Today’s environment of tight monetary policy, higher-for-longer interest rates, and weak earnings strongly favors the quality factor, and it consistently ranks near the top in our factor work. The biggest risk to a quality bias is a pivot from the Federal Reserve that ushers in a new era of easy money. We see that as unlikely but are prepared to adjust portfolios accordingly. Across portfolios we hold a slightly defensive posture, with a modest underweight to equities and overweight to cash and investment-grade fixed income.
1This methodology is consistent with MSCI’s factor methodology and similar to Barra’s.
2Source: Factset, as of January 20, 2023.
3 Source: Strategas Research Partners. Reflects the average since 1990.
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The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market.
Russell 2000 Index measures the performance of approximately 2,000 smallest-cap American companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. stocks.
S&P 500 index measures the performance of approximately 500 widely held common stocks listed on U.S. exchanges. Most of the stocks in the index are large-capitalization U.S. issues. The index accounts for roughly 75% of the total market capitalization of all U.S. equities.