Quality Factor ETFs: Strong Companies
Quality is the factor that buys financially strong companies — high profitability, low debt, steady earnings. Here's how it's measured and where it earns its keep.
Don't have time? Here's what you need to know:
- 1The quality factor favors profitable, low-debt, stable-earnings companies; QUAL scores stocks on high ROE, low debt-to-equity, and earnings stability.
- 2Quality has a strong academic basis (Novy-Marx, 2013, on gross profitability) and historically holds up better than the broad market in downturns.
- 3Definitions vary — QUAL, DGRW, and MOAT all target financial strength but with different recipes, so their holdings differ meaningfully.
- 4Quality pairs well with value because profitability filters out value's most fragile companies; it tends to lag in sharp low-quality rebound rallies.
Owning the Financially Strong
The quality factor tilts toward companies that are financially healthy: highly profitable, lightly indebted, and consistent in their earnings. Unlike value, which asks 'is this stock cheap?', quality asks 'is this a good business?' The two questions can point in opposite directions — a quality screen often lands on expensive, well-run companies, while a value screen lands on cheap, troubled ones.
Quality entered the factor canon later than value and size, but it has a strong rationale. Robert Novy-Marx's 2013 research showed that gross profitability — a clean measure of how much a company earns relative to its assets — predicted returns about as well as value did. The intuition is simple: durable, profitable businesses compound shareholder capital more reliably and survive downturns that sink weaker firms.
How Quality Is Measured
There is no single universal definition of quality, which is why quality ETFs vary more than, say, value ETFs. Most indexes combine a handful of accounting metrics into a composite score. The largest U.S. quality fund, QUAL, tracks an MSCI index that scores stocks on three pillars: high return on equity, low financial leverage (debt-to-equity), and stable year-over-year earnings growth.
Other funds emphasize different traits. DGRW blends quality and dividend growth, screening for profitable companies with the capacity to keep raising payouts. MOAT takes a related but distinct angle — it holds companies with durable competitive advantages ('economic moats') trading at reasonable prices, blending quality with a dose of value discipline. The common thread is financial strength, but the recipes differ.
| Metric | What it captures | Why quality favors it |
|---|---|---|
| Return on equity (ROE) | Profit generated per dollar of equity | High ROE signals an efficient, profitable business |
| Debt-to-equity | Reliance on borrowed money | Low debt means more resilience in downturns |
| Earnings stability | Consistency of profits over time | Stable earnings are less likely to collapse in a recession |
Where Quality Earns Its Keep
Quality's most useful trait is defensiveness. Because it favors profitable, low-debt companies, a quality portfolio has historically held up better than the broad market in downturns, when leveraged and unprofitable firms get punished hardest. That makes quality a natural complement to value, which tends to be more cyclical and to suffer most in recessions.
Quality also tends to be lower-turnover than momentum, which keeps fees and tax events modest — QUAL's expense ratio sits around 0.15%. The trade-off is that quality can lag in sharp, low-quality rallies, when beaten-down or speculative stocks lead the recovery off a market bottom. Like every factor, it has cycles, but its risk profile is gentler than most.
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Fitting Quality Into a Portfolio
Quality pairs unusually well with other factors precisely because it offsets their weaknesses. Value's cheap-but-fragile companies become less risky when filtered for profitability — which is exactly why small-cap value funds like AVUV add a profitability screen. Pairing quality with value or low volatility can dampen the worst drawdowns of a factor portfolio.
As a standalone tilt, quality suits investors who want broad equity exposure with a defensive lean — closer to the market than a deep value or small-cap bet, but with a built-in bias toward survivors. It is not a market-beating guarantee; quality's premium, like the others, is modest and not assured. But of the major factors, it is among the easiest to hold through a full cycle.
Frequently Asked Questions
What makes a stock 'high quality' in a factor ETF?
Financial strength, scored by accounting metrics. QUAL, the largest U.S. quality ETF, screens for high return on equity, low debt-to-equity, and stable earnings growth. Other funds add or substitute measures like gross profitability or dividend-growth capacity. There is no single industry-standard definition, so quality ETFs vary more than value ETFs.
How is quality different from value?
Value asks whether a stock is cheap; quality asks whether the business is strong. A value screen often surfaces inexpensive, troubled companies, while a quality screen surfaces profitable, well-run ones that may not be cheap. The two factors are largely independent, which is why combining them — owning cheap, profitable companies — is a popular strategy.
Does quality protect against market crashes?
It has historically softened them, not prevented them. Because quality favors profitable, low-debt firms, it tends to fall less than the broad market in downturns, when leveraged and unprofitable companies are hit hardest. But it is still an equity strategy — it loses money in bear markets, just generally less than the index.
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Alex Harrington
CFA Level II Candidate, Finance & Economics
Alex Harrington is an independent ETF researcher and personal finance writer with over 8 years of experience analyzing exchange-traded funds. A CFA Level II candidate with a background in economics, Alex has reviewed 800+ ETFs and helped thousands of beginners build their first investment portfolios through clear, jargon-free education.
This content is for educational purposes only and does not constitute financial advice. Past performance does not guarantee future results. Consult a licensed financial advisor before making investment decisions.