Discover how JQUA targets a diversified exposure to quality businesses with high profit margins and low leverage levels to ensure that Investors are not exposed to unwanted risks.
US equity markets have enjoyed tremendously strong returns over the past 2 years, spurred by a resilient economy and market enthusiasm around artificial intelligence. In fact, the average monthly return throughout 2023 and the first 3 quarters of 2024 has been 2.1%, more than double the average monthly return of 1.0% seen over the past 35 years. Furthermore, the strong returns over the past 2 years have been accompanied by relatively low volatility and limited market drawdowns. Key themes looking ahead into 2025 and beyond are a more normalized return environment, market breadth, and implications for portfolios in a higher for longer scenario. While any sort of diversification away from market beta has not been needed recently, investors should be reminded that passively buying broad benchmarks may expose investors to unstable companies and unwanted risks. Instead, investors may want to consider a strategy that targets the highest quality businesses with high profit margins and low debt levels. The JPMorgan U.S. Quality Factor ETF (JQUA) seeks to own the highest quality stocks in each sector, which can help investors to weather market downturns and also participate in upswings.
Why it’s high time for high quality
Periods of high returns and low volatility are a goldilocks scenario for investors. Afterall, the positive relationship between risk and return implies that elevated returns should be accompanied by elevated volatility. The past year represents one of the strongest returns relative to realized volatility over the past 50 years (chart 1).
While current data suggests that the US economy continues to look healthy and outlooks remain generally constructive on 2025, it’s worth reminding investors that periods akin to what has been experienced recently do not tend to last. Looking at the 5 previous instances over the past 50 years where return/risk was as high as seen for the period ending October 2024, on average returns over the next twelve months were 75% lower, while next twelve months realized volatility was 60% higher.
While top line returns for US large cap indices have been very strong over the past two years, the source of those returns have been heavily concentrated in the “Magnificent 7.” Those 7 stocks accounted for 63% of the S&P 500’s 24% return in 2023 and 43% of the index’s 26% return YTD through November. From a backward looking perspective, this contextualizes how much investors did not need a diversified or differentiated approach to owning US Large Caps. In fact, the S&P 500 Index itself delivered 32nd percentile returns relative to US Large Cap Blend peers in 2023 and 31st percentile through the first 11 months of 2024.
More important is the forward looking perspective for market breadth. In some ways, the relative performance of the Magnificent 7 over the past 2 years can be justified by their earnings growth compared to the remainder of the index (Chart 3). Looking ahead to 2025, however, earnings growth of the Magnificent 7 is forecasted to stabilize at a lower level than experienced throughout 2023 and 2024 while at the same time the remainder of the stocks of index are forecasted to increase their earnings growth. This dynamic has the potential to reward more diversified stock portfolios moving into 2025 and beyond.
Beyond the backdrop of an outlook for a more normalized risk/return environment and an increase in market breadth, investors may also want to consider implications for security selection in an environment where interest rates stay higher for longer. Despite the Federal Reserve’s 50bps rate cut at it’s September meeting and 25bps cut in November, market expectations have been revised higher, now expecting less cuts in 2025 and extending the Fed cutting cycle. This has implications for companies rolling existing debt or potentially issuing new debt in the near future, and puts added to pressure on those companies to maintain cash flows to meet debt obligations. All together, this presents an opportunity where more profitable and less levered companies may be better positioned to whether an extended Fed cutting cycle than their peers, while traditional passive indexes may leave investors exposed to these lower quality stocks.
Against this backdrop, JQUA’s focus on higher-quality, stable companies offers a solution for staying invested through the uncertainties that may present themselves in 2025 and beyond. JQUA seeks to:
- Manage risk and limit losses during volatile periods. Quality showed its strength as an investment style in 2022, navigating volatile markets and functioning as a portfolio ballast. Going back to JQUA’s inception in November 2017, JQUA has successfully protected on the downside in all 3 periods of a 15% or more drawdown.
- Capture growth potential as markets recover. Quality stocks have historically outperformed the broad market across cycles, with less risk. Adding exposures now allows investors to access growth opportunities as they arise and enhance long-term return potential as we move through and beyond this market cycle.
Three-step process for constructing a high-quality equity ETF
As part of our suite of factor-based equity strategies, JQUA brings J.P. Morgan’s quantitative research, portfolio management, technology and trading capabilities to an ETF priced at just 0.12%. Rather than buy every name in the Russell 1000, the index targets the 200 to 300 highest-quality U.S. large cap companies across all sectors to offer similar sector exposure without the significant stock concentrations of traditional indexing.
Step 1: Align sectors with the market. JQUA’s process begins by matching the sector allocations of the Russell 1000, and realigning them back during each quarterly rebalance. We align sectors to the index to avoid sector bets and ensure that the exposure to high-quality companies is what drives the fund’s performance relative to the Russell 1000.
Step 2: Rank stocks within each sector. When determining the overall quality of each company, our rules-based approach ranks sector peers across 10 metrics based on three key quality pillars:
- Profitability – strong earnings and cash flow
- Financial risk – low leverage, high interest coverage, low share price volatility
- Earnings quality – consistent accounting practices
Step 3: Select and weight stocks. We own the highest-ranked companies in each sector and seek to avoid overconcentration, thereby reducing stock-specific risks while maintaining diversification and liquidity.
JQUA plays multiple roles in strong portfolios
With its targeted exposure to quality companies, JQUA aims to serve as a core holding alongside standalone value and growth strategies. It also aims to act as a core complement to round out existing portfolio positions or bolster overall quality exposure in one simple trade. Or, consider it as a tactical allocation as outlooks change in today’s fast-moving markets.
Looking ahead, we expect to see increased market breadth and dispersion among company fundamentals as winners and losers emerge from the evolving economic backdrop. As always, we will look to improve on traditional beta by separating the most attractive stocks from the rest of the broad index.