This website uses cookies in order to improve user experience. If you close this box or continue browsing, we will assume that you are happy with this. For more information about the cookies we use or to find out how you can disable cookies, see our Cookies Notice.

Quality merchandise

Some equity long/short strategies still offer upside while providing "flight-to-quality" downside protection

We continuously look for ways either to increase our portfolios' returns without adding risk or to reduce risk without having to give up returns. According to yesteryear's conventional wisdom of market efficiency, this should be impossible. This year's winner of the Nobel prize in economics, Richard Thaler, begs to differ and has spent his professional career identifying and trying to explain various phenomena we see in practice that should not exist according to economic theory. These are commonly known as "anomalies" and can allow hedge funds to generate returns uncorrelated to broader markets.

We recently turned our attention to the so-called "quality anomaly" in equities: that is, the tendency of high-quality stocks to exhibit high risk-adjusted returns, beating the market over time. This is a puzzle, as this effect should eventually have been arbitraged away. A living proof of its longevity is the legendary investor Warren Buffet, who famously likes buying quality merchandise when it is marked down, whether it's "socks or stocks." Of course, judging the quality of a sock is somewhat easier. For stocks, we use both an intuitive and a practical definition of quality. At the risk of sounding tautological, a high-quality company is simply consistently better than most other companies. That could mean a superior financial performance, better management and/or a more shareholder-friendly attitude than its peers. Metrics commonly used to measure quality include return on invested capital, profitability and leverage as well as payout- and cash-flow-related measures of efficiency.

High-quality stocks have indeed generated significant excess returns over time. These returns can be achieved by buying high-quality companies and shorting the market and/or shorting low-quality companies. In both cases, excess returns are positive over time. # What could explain this anomaly? Perhaps investors prefer lower-quality, "lottery-ticket" types of stocks rather than "boring," predictable high-quality stocks. If so, this would explain why the quality anomaly appears contingent on the broader market sentiment. The strategy generally underperforms in highly "risk-seeking" environments, which by definition skew investors' preferences to more uncertain investments. It instead performs well during periods of market selloffs: as an example, a strategy of long quality stocks and short "junk" stocks would have generated a very strong positive performance in 2008.

In recent months, the equity-market rally has been driven primarily by stocks that happen to be high-quality companies: they are highly cash-generative, they have very profitable business models and are scoring well on most quality metrics. This suggests that the recent equity rally is different from previous ones because of its quality bias. In the late 1990s, equity markets were driven by technology companies that were largely untested business models. Back then, quality-based investment strategies underperformed the broader market. In the 2000s, the market rose independently from quality elements, hence quality-based investment strategies would have been roughly flat. Since the global financial crisis, such strategies have moved through periods of flat performance when equity markets were rallying and strong returns in "risk-off" periods.

We favor an overweight to quality-driven investment strategies in the medium term. We see signs that after a long-lasting equity bull run, investors are "rotating into quality." We think that high-quality, market-leading companies should continue to be the most likely candidates to deliver earnings growth and therefore still offer upside potential while providing a level of "flight-to-quality" downside protection. To be sure, today's high-quality businesses may not maintain their status forever. We think that quantitative measures of quality play an important role, combined with qualitative assessments by experienced investors. With quality-driven investments, as in other areas of the hedge-fund universe, diligent strategy selection is paramount.

Long-term returns from favoring quality stocks

The quality anomaly has generated significant excess returns over time by buying high-quality companies and selling low-quality ones.

Source: AQR Capital Management, LLC as of 8/31/17

How a quality-based strategy has outperformed

The strategy performed well in "risk-off" and "flight-to-quality" scenarios. This was partially reversed when markets rebounded.

Source: AQR Capital Management, LLC as of 8/31/17

* Returns in excess of risk-free rate

** Excess-return index including all global stocks weighted by market capitalization

1

See Asness, Clifford, Frazzini, Andrea and Pedersen, Lasse (2013) "Quality Minus Junk", Working paper, available online: http://www.econ.yale.edu/~shiller/behfin/2013_04-10/asness-frazzini-pedersen.pdf.

Related Articles

Jul 03, 2018 Investment Traffic Lights

Investment Traffic Lights

Our tactical and strategic view

Jun 08, 2018 Americas CIO View

Americas CIO View

Is it time for U.S. Small Caps to shine? If you pick them right

Jun 04, 2018 Investment Traffic Lights

Investment Traffic Lights

Our tactical and strategic view

May 29, 2018 CIO Flash

Euro crisis 2.0?

Italy's political woes are dragging down markets while boosting our dollar call.

May 29, 2018 Americas CIO View

Americas CIO View

What do investors want from active managers?

May 24, 2018 CIO Flash

Italy's new coalition

Italian political turmoil might prove less worrisome than many think.

May 24, 2018 Americas CIO View

Americas CIO View

Oil near normal, Energy profits still below, but limited upside

May 18, 2018 Chart of the week

Chart of the week

Even U.S. corporations fear the impact of Donald Trump's trade politics

May 09, 2018 Americas CIO View

Americas CIO View

Neither higher wages, oil, nor federal funds rates threaten margins

May 03, 2018 CIO View QuarterlyFocus Topic

Rising interest rates

Will rates unrattle equity markets?

May 03, 2018 Investment Traffic Lights

Investment Traffic Lights

Our tactical and strategic view

Apr 30, 2018 Americas CIO View

Americas CIO View

Volatility: Be contrarian short-term, but respect it longer-term

Apr 24, 2018 Americas CIO View

Americas CIO View

Sizing up Banks and Tech

Apr 17, 2018 CIO View QuarterlyMulti Asset

Managing volatility

The markets' increased volatility should be manageable.

Apr 17, 2018 CIO View QuarterlyLetter to Investors

One more year

Markets are shaky, but a bear market is unlikely without recession.

Apr 17, 2018 CIO View QuarterlyForecasts

Our forecasts

All forecasts at a glance

Apr 16, 2018 CIO View QuarterlyEquity

Hold your nerve

Based on our growth and interest-rate forecasts, we remain bullish on stocks.

Apr 16, 2018 Americas CIO View

Americas CIO View

Economic EPS growth: Does any region have it this cycle?

Feedback

Please let us know what you think about this article/page.