Scientific Beta

Quality investing offers the potential for long-term outperformance of the broad equity market. However, quality strategies are implemented via a wide range of approaches. These implementation choices may lead to three important pitfalls, which the Scientific Beta Quality index has been designed to avoid.

Quality investing offers the potential for long-term outperformance of the broad equity market. A large body of academic literature provides evidence that high-quality firms earn higher long-term average returns than low-quality firms. Consequently, many investors pursue quality investment strategies. The Scientific Beta Quality index offers a  new approach to implement such a strategy.

A first key question for quality investors is how to define a high-quality firm. We include firms with a high profitability and low investment in our quality stock selection. This parsimonious definition follows extensive evidence that these characteristics allow to distinguish between firms with high and low average long-term returns. Several other commonly used metrics, such as leverage and earnings stability, have been shown to lack robustness.

High-quality firms may include quality traps. These are firms that introduce a long-term performance drag because of their high valuation, high volatility, or low momentum. Our quality index explicitly removes quality traps from the stock selection. Therefore, the outperformance potential introduced by the quality tilt is not offset by a performance drag introduced by firms with these undesirable characteristics.

Quality strategies often have a defensive tilt, with an average market beta below one. Such strategies will therefore underperform the market during bull markets and miss out on part of the long-term equity risk premium. Furthermore, the market beta can be highly unstable over time. Variability in market beta means that investors take on implicit bets on market performance over short horizons. The weighting scheme of our quality index includes a mechanism that targets a stable market beta of one. As a result, the index delivers a smooth outperformance across market regimes and captures the full equity risk premium. Stable exposure to the market further ensures that investors do not take undue bets on short-term performance.

These index design features deliver robust performance across regions. During our sample period, our quality index delivered a relative return over the market index of 2.1-2.4%, with a comparable level of volatility. Such results are driven by a strong quality tilt and the avoidance of quality traps. The stable market beta of close to one results in a similar outperformance during both bull and bear markets. Figure 1 highlights how our index design features work together to deliver strong long-term returns, with a cumulative outperformance over the cap-weighted market index of 160% over the past forty years.

Figure 1: Historical quality index performance vs market index

Notes: Cumulative returns are based on monthly USD total returns from 30 June 1984 to 31December 2023. The universe is the EDHEC Risk Long-Term Track Record Developed universe. The outperformance corresponds to the excess returns of the Quality index relative to the Cap-Weighted market index.