This fund favors highly profitable firms with durable competitive advantages.

by Alex Bryan
Invesco S&P 500 Quality ETF SPHQ

Invesco S&P 500 High Quality ETF SPHQ has gotten better over time. It recently cut its fee and, in June 2016, switched to a more transparent index, which targets firms with strong cash flows and balance sheets. It should hold up better than most of its peers during market downturns and offer attractive performance over the long term. This strategy warrants an upgrade to a Morningstar Analyst Rating of Silver from Bronze.

Quality is a bit subjective, but the fund effectively targets firms with strong profitability and balance sheets, which are important dimensions of quality. It targets 100 stocks from the S&P 500 with high return on equity, low growth in net operating assets during the most recent year (which is a proxy for capital expenditures), and low financial leverage. Firms with high return on equity and low growth in net operating assets tend to have high free cash flows, which they can use to fund dividend payments and share repurchases or pay down debt. Stocks that make the cut are weighted according to both the strength of their quality characteristics and their market capitalization, subject to a 5% cap.

Highly profitable firms with durable competitive advantages, such as Procter & Gamble PG, Visa V, and Starbucks SBUX, anchor the portfolio. These firms have tended to be slightly less sensitive to the business cycle than average and hold up a little better during market downturns, though that has not always been the case. For instance, during the bear market from Oct. 8, 2007, through March 9, 2009, the fund's index lost slightly more than the S&P 500.

Prior to June 30, 2010, the fund did not have a quality mandate. On that date it switched to the S&P 500 High Quality Rankings Index following a period of poor performance. It switched again in March 2016 to the S&P 500 Quality Index, which applies a more-transparent quantitative methodology. Invesco cited this transparency as the reason for the change. Because of these changes, the fund does not have a long record tracking its current benchmark. The back-tested performance of its index looks good, but as always, it is prudent to discount such hypothetical performance.

Portfolio Construction

The fund employs full replication to track the S&P 500 Quality Index, which accurately represents the quality investment style. This transparent, well-crafted index targets stocks that should provide better downside protection than the market and offer better risk-adjusted performance over the long term. It warrants an upgrade to a Process Pillar rating of Positive from Neutral. To construct the fund's benchmark, S&P assigns a composite quality score to each stock in the S&P 500 based on its return on equity, financial leverage (total debt/book value of equity), and net operating asset growth during the past year, divided by average net operating assets. S&P calls the last metric an accruals ratio, and a lower value is associated with higher quality. It ranks the members of the S&P 500 on the composite quality score and selects the top 100 for inclusion in the quality index. Qualifying stocks are weighted according to both their market cap and the strength of their quality characteristics, subject to a cap of 5%, or 20 times their market-cap weighting. The fund's index applies a buffer rule to mitigate unnecessary turnover, which should help reduce transaction costs. However, turnover was still 60% in the most recent year. The index reconstitutes semiannually in June and December.


Invesco cut the fund's expense ratio to 0.15% from 0.29% in August 2018 to match QUAL. This cut is good for investors and makes this one of the cheapest quality funds available. It earns a Positive Price rating. Over the trailing 12 months through November 2018, the fund lagged its benchmark by 26 basis points.

S&P 500 index data: S&P 500 Copyright @ 2019

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