When Bad Things Happen to Good Stocks


In this year’s market bloodbath, you might think funds with “quality” in their name—and in their holdings—would lose less money.

You’d be wrong.

Quality funds, in Wall Street lingo, tend to own companies that are highly profitable, with steady earnings growth and low debt. In principle, such stocks as

Home Depot Inc.,


HD 0.36%

Microsoft Corp.


MSFT -0.60%

and

3M Co.


MMM -0.59%

are among the bluest of the blue chips. In practice, many funds holding them are in the red.

Over the past few years, exchange-traded funds specializing in quality stocks have grown to more than $60 billion. With the S&P 500 down 20% this year, several of these ETFs have fallen even harder, losing as much as 25%.

“It may have come as a shock to many investors that quality hasn’t been performing defensively” in this year’s market rout, says Denise Chisholm, director of quantitative market strategy at Fidelity Investments.

Andrew Ang,

a managing director at

BlackRock,

points out that quality companies typically earn more of their profits farther into the future than cheap “value” firms do—making their earnings less valuable in a time of rising inflation and interest rates.

Part of the problem is that quality is in the eye of the beholder.

Among the various factors that can contribute to returns—a company’s market capitalization, how expensive the stock is, its recent price behavior and so on—“quality is probably one of the most vaguely defined,” says Savina Rizova, global head of research at Dimensional Fund Advisors in Austin, Texas.

“Quality seems like a good feature to have in a company—but not quality at any price,” she adds.

Some funds, like those at Dimensional, focus on companies’ profitability—their operating profit, divided by net worth. That approach has lost less money than the overall market this year.

Other funds also toss in steady earnings growth, high cash flow, low debt or the rate of change in net operating assets, among various measures.

Still others aim to own companies with strong “moats,” meaning that they seem likely to be able to outcompete their rivals for years to come.

By the beginning of this year, some quality funds held larger than average positions in technology or healthcare stocks. After all, those are among the industries that had shone brightest on these measures over the past few years.

Unfortunately, they also were expensive. “A lot of these great companies are so well-run, efficient and profitable that everyone wants to own them, so they tend to trade at premium valuations,” says Brandon Rakszawski, a senior product manager for the

VanEck Morningstar Wide Moat

ETF.

In a falling market, the easiest and least painful way for investors to raise cash is to sell off their biggest winners first. That’s contributed to a wave of selling in some of the top-performing—and highest “quality”—stocks of the past few years.

Facebook’s

parent Meta Platforms Inc. is down more than 57% so far in 2022; Google’s holding company,

Alphabet Inc.,

is off 31%;

Abbott Laboratories

has lost 27%.

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Another disappointment: “You would think that in inflationary environments, companies with high profitability would be able to weather that storm better, but it hasn’t really played out here, at least not so far,” says Nick Kalivas, head of factor and core ETF strategy at Invesco.

Over the past three decades, says Ms. Chisholm of Fidelity, quality stocks have outperformed about 80% of the time when economic conditions were deteriorating.

So investors may have come to regard quality stocks as a panacea against bad markets—bidding them up to prices that weren’t sustainable.

Even after their recent pounding, quality stocks are still more expensive, relative to the market as a whole, than they’ve been 90% of the time since 1990, says Ms. Chisholm.

A look at the markets shows asset managers are moving money around in ways that suggest they see a recession coming. WSJ’s Dion Rabouin explains what to look for and why they tell us investors are increasingly pricing in a recession. Illustration: David Fang

Along with value, momentum, low volatility and several other characteristics, quality is one of the factors that investment researchers say have generated higher performance than the market as a whole in the past.

It’s never certain, however, that investing in any particular one of these factors will provide a durably superior return in the future—especially given the perennial tendency of investors to jump in with both feet after a period of hot performance only to bail out when returns go cold.

If, on the other hand, you own all the factors all the time, then your returns will converge toward those of an index fund that holds the entire stock market—which you could own at a fraction of the cost of most factor funds.

SHARE YOUR THOUGHTS

What factors appeal to you when evaluating a potential investment? Join the conversation below.

One thing is sure: People who bought quality ETFs at the peak of their popularity haven’t gotten the bulletproof performance they hoped for.

As fund companies were launching the first of these portfolios almost a decade ago, I wrote:

“There’s no rush. Let the funds launch and get seasoned. See whether the managers can deliver. Then wait some more, sitting out the inevitable boom in popularity. Before long, investors will be complaining that quality is overrated and that other investing styles work better.

“Mark my words: At that point you will be able to get quality in quantity.”

That point is finally getting closer, but we’re not there yet.

Write to Jason Zweig at intelligentinvestor@wsj.com

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