As the longest bull market in history has come to an end, the phrase ‘unprecedented times’ has arguably become a cliché. Whilst admittedly there would be few of us alive to have witnessed an event-driven correction of this magnitude, from an economic standpoint we may be on familiar ground.

The last economic cycle could be characterised by low economic growth, record low interest rates and generally stagnant profit growth. An environment in which, over the past decade, investors searched for dependable, secular growth in a low-growth world, demonstrated by the chart below comparing the performance of a quality factor index (orange) vs a vanilla broad market equivalent (grey).

Source: Morningstar Direct, BetaShares. Total returns in AUD over 10 years to 31^st December 2019. You cannot invest directly in an index. Past performance is not an indicator of future performance of the index or any ETF that aims to track the index.

Looking ahead

Whilst the recent correction came unexpectedly, the next economic cycle looks set to begin on similar fundamentals.

The current economic outlook is dire, and in many cases has continued to weaken beyond expectations. This has further exacerbated the disconnect between those companies able to provide sustainable growth, and those that cannot.

Whilst we have seen glimmers of tactical reallocations to cyclical names in the hope of recovery, on the whole we are likely to see low nominal GDP and earnings growth, and central bank policy looks set to ensure record low interest rates persist.

A change in market leadership remains unlikely, and from a strategic standpoint, longer-duration, high-quality growth companies that are able to offer predictable and stable return on equity (ROE) should remain attractive over the medium to long-term.

Quality Defensive Growth

How can we identify these sorts of companies? Typically, the metrics used to identify ‘quality’ include:

• High and sustainable ROE
• Profitability
• Earnings stability
• Financial health

Historically, companies with these factors have tended to outperform during the slowdown and contraction phase of the economic cycle and have typically demonstrated lower volatility and lower drawdowns than the broader global market in falling markets and periods of heightened volatility.

For example, as illustrated in the chart below, during the Global Financial Crisis (Oct 07 – March 09) the iSTOXX MUTB Global ex-Australia Quality Leaders Index outperformed the MSCI World ex Australia Index by ~19%.

Source: Morningstar Direct, BetaShares. Data as at 31^st May 2020. You cannot invest directly in an index. Past performance is not an indicator of future performance of the index or any ETF that aims to track the index.

Quality companies with durable business models and sustainable competitive advantages are potentially better-suited to weather the economic cycle – and as we have seen during the recent crisis, when the ‘flight to quality’ occurs, investor focus has tended to return to current profitability rather than promises of future revenue growth.

In addition to the drawdowns being less severe, the historical road to recovery has also tended to be shorter for these ‘quality’ companies.

How to access quality?

Many of these metrics are used by active fund managers as part of their stock screening, however this often comes at the cost of high fees.

An alternative method to gain diversified exposure is through Exchange-Traded Funds (ETFs), which enable investors to gain exposure to a fund that aims to track an index specifically designed to capture a portfolio of companies displaying these characteristics.

Removing the ‘active’ component means investors can access a lower-cost quality factor ETF on the Australian market for management costs as low as 0.35% p.a (1)

Do you get what you pay for?

“Pay peanuts, get monkeys”, the saying goes. While this may ring true in many areas, over the long run, the evidence suggests this does not necessarily apply to high management fees when it comes to investment funds.

The chart below illustrates the relationship between management fees (x axis) and investment returns (y axis) over both 5 years (orange) and 10 years (blue) (to 31 May 2020), and shows a linear trend between higher management fees and diminishing investment returns across both time horizons. The data relating to the iSTOXX MUTB Global Ex-Australia Quality Leaders Index (net of 0.35% p.a. management costs ) has also been included for illustrative purposes.

Source: Morningstar Direct, BetaShares. Data as at 31^st May 2020. The graph shows return of index that the BetaShares Global Quality Leaders ETF (ASX: QLTY) aims to track (taking into account QLTY’s management costs of 0.35% p.a. (1)). The index which QLTY aims to track is the iSTOXX MUTB Global Ex-Australia Quality Leaders Index. You cannot invest directly in an index. Past performance is not an indicator of future performance of the index or any ETF that aims to track the index.

The long-term value of an equity strategy which focuses on quality metrics should not be overlooked, particularly in uncertain times. The quality factor index has been able to demonstrate superior returns against the top quintile of fund managers in its category.

Source: Morningstar Direct, BetaShares. Data as at 31^st May 2020. You cannot invest directly in an index. Top quintile refers to the 20^th percentile of Open Ended Australian domiciled Global Growth Equity funds as defined by Morningstar. You cannot invest directly in an index. Past performance is not an indicator of future performance of the index or any ETF that aims to track the index.

Summary

In a world of anaemic growth, quality companies which have been able to demonstrate consistent and sustainable ROE historically have tended to show better performance compared to the broader market.

Whilst the longest bull market cycle may have come to an end, the correction appears to have been limited to a health crisis, rather than being a product of systemic issues, such as banking system failures or rising interest rates. As such, we may see limited change in economic backdrop.

Equity market valuations are returning to near all-time highs, leaving little buffer for leveraged companies with poor balance sheets against any future negative shocks if this does become more of a cyclical issue.

Whilst cyclically-exposed and value parts of the market can see short-term bounces on the expectation of economic improvement, over the longer term the premium associated with high quality stocks may continue to provide more favourable investment returns. As such, a change in market leadership looks unlikely at least in the near term.

Australian investors are able to access quality-based strategies via ETFs, which can form a diversified core of portfolios looking to benefit from the premium associated with companies which display consistently high ROE, for lower fees compared to actively managed investment options with similar investment strategies.

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1. Management cost applicable to the BetaShares Global Quality Leaders ETF (ASX: QLTY). Other fees and costs, such as transactional costs, may apply. Refer to the PDS for more information.

There are risks associated with investment in the BetaShares Global Quality Leaders ETF (ASX: QLTY), including market risk, index methodology risk, international investment risk, concentration risk and currency risk. For more information on risks and other features of QLTY, please see the Product Disclosure Statement.