The quality factor: Its impact, foundation, and evolution

The investment landscape of the last 18 months has been unusual in many respects. Looking back, much of the rally has been driven by risk aversion easing back as black swan events were either avoided or diluted in probability. But while headline equity market returns might imply a robust economic backdrop, index returns were achieved despite an economic deceleration—but also because of a heavy concentration in a handful of stocks, most notably, the “Magnificent Seven”¹ (Figure 1). While these stocks might be loosely bonded by the emerging theme of artificial intelligence (AI) and its infrastructure and future applications, the extreme return concentration over that period merits deeper consideration.

The market capitalization of the Magnificent Seven stocks is one clear linkage, but a key thread when looking at equity returns over the past decade has been a collective improvement in the quality of these companies. This show of quality intertwined with the expectation of future growth and improvement, and stemming from the AI revolution, is at the heart of why these companies have dominated equity returns.

What is quality, and does it work?

Factor definitions—including size, momentum, volatility, growth, and value—have long been viewed with a high degree of consensus among practitioners and academic researchers. While there are variations in the precise metrics used for definition, many factor concepts are widely accepted and understood by investors.

Quality, either as a factor or as an investing style, is a notion that lacks a universally agreed‑upon definition, however. This makes quality harder to identify and capture, despite strong consensus and evidence that it has strong linkages to financial returns within equity markets.

We examined quality from both a quantitative and qualitative perspective with a goal to understand its foundations, its impact on returns, and its redistribution in an ever‑increasing digital world. As a starting point to understand why quality is a much‑debated concept, we compared the MSCI ACWI² with the MSCI ACWI Quality (Figure 2). While there are many definitions available, the MSCI ACWI Quality aims to capture the performance of quality‑growth stocks by identifying securities with high quality scores based on three main fundamental variables: high return on equity (ROE), earnings stability, and low financial leverage.³

Outperformance of the quality index is notable, even more so when considering the five‑year rolling relative return of the quality index, which exceeds its mainstream equivalent in 85% of observations since 1997 (Figure 3). At least through the lens of one index definition, quality has been a consistent outperformer, albeit with cyclicality and notable periods of drawdown.

This cyclicality is better observed through an evaluation of shorter‑term data. In Figure 4, we show the same analysis over a rolling six‑month time frame, observing that the quality index often experienced underperformance during extreme risk‑on periods. These have often followed in the wake of crisis‑type events. This pattern is intuitive given that such recovery periods are often defined by broad‑based improvement and high‑risk tolerance. The exit from the financial crisis of 2008–2009 and the reopening of the global economy following the COVID‑19 pandemic are two such examples of quality underperformance.

With each observation representing six‑month periods rolled one month forward, we found that in 65% of observations, the MSCI ACWI Quality produced positive excess return relative to the MSCI ACWI. Midcycle and/or less directional markets are where quality tends to deliver a return advantage, especially where a scarcity component emerges. This growth scarcity was evident in 2023, and also in the period preceding the pandemic, where economic and earnings growth were muted. As with any scarce commodity, as growth becomes harder to come by, investors are more willing to pay a premium.

The more recent outperformance of quality has been driven by the absence of broad economic and earnings growth, in tandem with a concentration of earnings growth centered on the Magnificent Seven (Figure 5), a group of stocks that has risen in significance for quality investors.

 

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