VFQY: The Quality ETF With A Strong Value And Small Cap Tilt

With a slowing economy that might be on the verge of a recession, quality stocks are shining. Quality stocks have strong balance sheets and hence low default risk. When the economy slows down this is a valuable feature. In such an economic backdrop the Fed normally stops hiking rates and in such a rate environment quality stocks have historically outperformed. Quality is together with Growth the best-performing equity factor.

The performance of value and small-cap stocks is less stellar as they are hampered by rising interest rates.

Figure 1: Total return chart (Radar Insights)

The recent drop in interest rates is a tailwind for value and small-cap stocks. The Vanguard U.S. Quality Factor ETF (BATS:VFQY) is a quality ETF with a strong value and small-cap tilt. These tilts might be an interesting feature to favour VFQY over other quality ETFs.

Figure 2: Total return chart (Radar Insights)

Over the past 12 months, the best-performing quality ETFs are iShares MSCI USA Quality Factor ETF (QUAL) and the more defensive JPMorgan U.S. Quality Factor ETF (JQUA). Also, the Wahed FTSE USA Shariah ETF (HLAL) is performing nicely (more info here and here).

The only quality ETF that’s not outperforming the S&P 500 is VFQY.

Figure 3: Total return chart (Radar Insights)

Over the past month, VFQY is however the best-performing quality ETF, thanks to its value and small cap tilt.

Figure 4: Total return chart (Radar Insights)

Will this trend continue?

Vanguard U.S. Quality Factor ETF

The Vanguard U.S. Quality Factor ETF is benchmarked to the Russell 3000 Index, which measures the performance of the largest 3,000 companies (representing approximately 98% of the investable U.S. equity market). This gives VFQY a small cap-tilt.

Figure 5: Market cap breakdown (Vanguard)

The iShares MSCI USA Quality Factor ETF in comparison is benchmarked to the MSCI USA Sector Neutral Quality Index and doesn’t take any sector bets compared to the S&P 500 and can be labeled large-cap growth.

The small cap and value tilt moves VFQY away from large cap growth to a more balanced profile, both for value/growth and size.

A look at VFQY’s equity factor exposure shows that the factor betas for size and value are currently even higher than the quality factor beta.

QUAL on the other hand is a pure quality ETF, with factor betas for value, size, low volatility and momentum close to zero.

The higher weight of value and size gives VFQY a cheap valuation, with a P/E of less than 15!

We are honestly a bit surprised that VFQY’s return on equity is lower than the Russel 3000. VFQY uses a rules-based quantitative model that focuses explicitly on return on equity. Other measures they use are gross profitability, change in net operating assets, and leverage.

The rules based portfolio composition model results in a portfolio with Technology as the biggest sector.

But compared to QUAL, VFQY is underweight Technology and Communication Services and overweight Industrials and Financials and Consumer Discretionary.

Figure 12: Sector drift (ETFresearch.com)

Those overweight sectors are among the best performing sectors (together with Real Estate) over the past month.

Figure 13: Total return chart ( Radar Insights)

VFQY better diversified than QUAL which has almost 40% invested in the top 10 holdings. For VFQY this is less than 15%.

VFQY’s value and small cap tilt might be an interesting feature to favour VFQY over other quality ETFs.

Small caps and value stocks

Let’s first take a look at the outlook for small caps.

Small caps are underperforming because they tend to have weaker balance sheets with more floating rate debt and hence higher interest expenses. If the Fed starts cutting rates this will be a strong tailwind for small caps. If we can avoid a recession and have a soft landing this will also favour small caps. We saw already the impact of lower long-term interest rates on the small cap performance the last month. And small caps are also very cheap. This can be another tailwind going forward.

Figure 15: Small cap valuation gap (Bloomberg)

Research by Hamilton Lane discusses the impact of loss making firms on valuations. This impact is stronger among small caps because there are simply more loss making companies among small caps.

Figure 16: Percentage of loss making firms Russell 200 Index (Apollo)

If one excludes loss making firms, the remaining small caps (in e.g. the Russell 200 Index) are even cheaper compared to the index including those firms. This is important for VFQY because it uses (gross) profitability and return on equity as measures to select quality stocks.

Just like small caps value stocks are underperforming, certainly in comparison with growth stocks.

Figure 17: Value vs growth performance (Bloomberg)

Outside the US, where the impact of the AI boom is less outspoken, value is performing better. The Magnificent 7 is truly a US story.

Just like small caps value stocks are, value stocks are cheap, certainly in comparison with growth stocks.

Figure 19: Value vs growth valuation spread (Bloomberg)

Quality remains in a strong long-term uptrend. The situation is improving for Value and Size although Value is not (yet?) in a clear uptrend.

All quality ETFs are in a long-term uptrend, with the highest score for QUAL and… VFQY.

Conclusion

We don’t know if we are already in a recession or not, but the Fed is certainly slowing down the economy with its rate hikes. Quality tends to outperform when the Fed ends hiking rates and when the economy is slowing down or is in recession.

It seems the Fed is indeed done raising interest rates. Long-term interest rates are coming down and this supports value and small cap stocks. This is a tailwind for VFQY. We remain positive about quality stocks in general and QUAL in particular. But VFQY is a nice complement and diversification for your quality stock allocation.