Discover how JQUA targets quality businesses with high profit margins and low debt levels to ensure that investors are not exposed to unwanted risks.
2022 ushered in a new market regime from a variety of perspectives. The Fed raised rates at a voracious pace, inflation hit new highs, and slowing economic growth gripped markets. The confluence of these events challenged markets significantly, with the S&P 500 suffering its worst year since the Financial Crisis and leading to a stark divergence in performance across individual stocks. Among many of the lessons learned in 2022, one that many investors were reminded of is 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
While additional fiscal and monetary support during the depths of COVID proved to provide oxygen to markets in the back half of 2020 and throughout 2021, the reversal of accommodative policies ravished markets in 2022. Company fundamentals have now been thrust to the forefront amid a challenging economic outlook and a downbeat corporate earnings outlook. The latest earnings estimates range from steep declines in more sensitive sectors like energy and materials, to modest growth in more insulated industries such as technology and utilities.
Meanwhile, the financial risk of companies has been elevated, as many companies who funded growth through leverage at very low rates may face significant challenges rolling that debt at much higher rates and/or maintaining a cash flow in a slower economy to meet on-going debt payments. All together, this has raised solvency concerns among the more financially vulnerable holdings in traditional indexes. Against this backdrop, JQUA’s focus on higher-quality, stable companies offers a solution for staying invested through the uncertainties. 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 now 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 discrepancies among company fundamentals as winners and losers emerge from the challenging 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.