A Market Rotation Toward Quality Will Benefit These 3 ETFs

Key Points

• As the market surges ever higher and valuations become increasingly stretched, a shift toward quality may become more attractive.
• Quality-focused factor ETFs have tended to slightly underperform the broader market this year, but may offer other reasons for investors interested in rotating out of momentum names.
• QUAL, DGRW, and VFQY all present different takes on "quality" as an investing factor.

With the S&P 500 pushing to higher and higher record levels in recent months, many investors are increasingly concerned about the bottom dropping out. Chasing momentum loses its appeal when valuations seem to be stretched uncomfortably thin. In this case, it may be more prudent to seek out targets with predictable earnings and cash flow—in other words, companies that signal "quality" via high returns on invested capital, consistent growth, strong balance sheets, and so on.

Those looking to pivot toward quality but finding it difficult to select individual names can turn to any of a number of exchange-traded funds (ETFs) based on this factor. Quality has a broad definition in the investment world and can mean profitability, stability, balance sheet strength, cash flow generation, and more, so investors would be wise to consider how any quality-focused ETF defines this factor before building exposure.

A Modestly Priced Quality Fund With a Dividend Add-On

The iShares MSCI USA Quality Factor ETF BATS: QUAL follows an index of large- and mid-cap domestic companies selected for consistent earnings growth, minimal debt, and a high return on equity.

As one of the earlier ETFs with a factor focus, QUAL helped to set the stage for a number of more recent funds taking a similar approach. Its 129 holdings lean fairly heavily on major tech firms but also include smaller names and other sectors as well. Still, investors will probably not find this portfolio to be sufficient as a means of accessing the broader U.S. market.

Though not a dividend fund, QUAL does offer a modest dividend yield of 0.9%. Given that the fund's year-to-date return is about 8%, somewhat below the broader market, the dividend bonus may help to further entice some investors looking for a more competitive performance in the last few months. Still, a quality-focused fund may not be the place to go to look for market-beating returns. Indeed, an ETF like QUAL is one to watch when the market takes a dip, to see if its strategy can help to insulate it from broader volatility. With an expense ratio of 0.15%, QUAL is not a particularly expensive fund, a fact that may help to convince more investors to take a chance (although its asset base and trading volumes are plenty robust as-is).

Higher Dividend, But Comes With Nearly Double the Fees

By contrast, the WisdomTree U.S. Quality Dividend Growth Fund NASDAQ: DGRW is a quality-themed ETF with a specific dividend focus: the fund provides a yield of 1.3%.

DGRW has a narrower purview than QUAL in that it only targets large-cap U.S. equities, but its nearly 200 positions means that the portfolio is actually more diversified in some ways that QUAL's.

Just because the basket has more positions, though, does not mean that concentration is not a concern. NVIDIA Corp. NASDAQ: NVDA, Apple Inc. NASDAQ: AAPL, and Microsoft Corp. NASDAQ: MSFT alone occupy a combined 20% or so of invested assets, for instance.

Still, returns of 8% YTD are comparable to QUAL but also remain behind the broader market. For investors comparing these funds, the question may come down to whether prioritizing dividend yield is worth a slightly higher fee—DGRW has an expense ratio of 0.28%, nearly double that of QUAL.

The Dark Horse Actively Managed Option

A third ETF focused on quality is the Vanguard U.S. Quality Factor ETF BATS: VFQY, which sets itself apart not only by being actively managed but also, surprisingly, by coming in with the lowest expense ratio of all three of these funds at just 0.13%. In this case, VFQY considers markers of quality to include profitability and overall financial health, among others.

VFQY is also distinguished from the other funds here by looking at the entire market capitalization spectrum when managers evaluate U.S. equities for inclusion. While VFQY still skews toward large companies—close to 60% of the portfolio is firms sized at $13 billion or greater—it does include a noteworthy portion of small- and micro-cap firms among its close to 450 holdings. With no single position representing even 2% of the portfolio, VFQY is not as reliant on the performance of individual names as the funds above, either.

Performance is slightly behind the other ETFs on this list at about 7% YTD, but VFQY does offer a compelling dividend yield of 1.1%.

Given the low price and ready-made diversification, VFQY may be uniquely attractive among quality-themed funds.