2023-11-24 11:30:21 ET
Summary
- After the market euphoria seen in 2023 where the S&P 500 index has gained nearly 19%, it is important to add some quality to your portfolio.
- This is possible through JQUA, an ETF that aims to provide investors with exposure to high-quality companies in the U.S.
- The differences in the composition and performance of JQUA and SPY further justify opting for the JPMorgan ETF.
- A 22% upside is targeted.
With over $426 billion in assets under management and incepted 30 years ago, the SPDR S&P 500 ETF Trust ( SPY ) is a highly popular passive fund that is trusted by many investors. However, after the fund gained nearly 19% for this year alone, the aim of this thesis is to show that it is time to add quality through the JPMorgan U.S. Quality Factor ETF ( JQUA ).
Noteworthily, JQUA has delivered a better performance over the last three years as shown below with this period including December 2021 to February 2023, when the stock market was highly volatile, mostly due to the Federal Reserve's aggressively hiking interest rates from March 2022.
More recently, inflation indicators showed some moderation prompting the U.S. central bank to maintain rates on the last two successive occasions, causing equities to rally. On top, the market has even started to price in rate cuts in 2024 with some signs of a soft landing starting to emerge.
However, the task of fighting inflation is an arduous one and the Fed's inflation target of 2% may be harder to achieve than is being expected, and, amid market optimism, few seem to be paying attention to risks.
SPY Faces Concentration Risks
First, one of the reasons for SPY's upside is that it tracks the S&P 500 index which is market cap weighted. This signifies that the weight of each component is determined by their respective size and that is why when you look at its holding breakdown, it is skewed towards relatively few of them. Thus, more than 7% of SPY's index underlying weight is allocated to Apple Inc. ( AAPL ) and Microsoft Corporation ( MSFT ) each, followed by Amazon.com, Inc. ( AMZN ) and NVIDIA Corporation ( NVDA ) with above 3% each. The weight progressively decreases as shown below, but together with Alphabet Inc. ([[GOOG]], [[GOOGL]]) and Meta Platforms, Inc. ( META ), the four above stocks constitute 27.2% of the S&P 500 Index underlying fund, signifying high concentration risks.
Now, these are the very stocks that have benefited from the enthusiasm around Generative AI which is an innovative flavor of artificial intelligence driving ChatGPT as of January this year, after Microsoft announced its sizeable investment in OpenAI. The company's chat-based application ChatGPT is driven by Generative AI, the new flavor of artificial intelligence that can bring billions of dollars of productivity gains across various industries.
Hence, productivity is the reason why artificial intelligence enablers have enjoyed so much investor enthusiasm, be it Nvidia through its GPU chips, Microsoft, by selling subscription services from its intelligent cloud infrastructure, or Apple, whose mobile and desktop devices are the gateways for accessing AI. Alphabet also has similar products such as Bard AI while Meta has invested heavily into AI both to improve social media experience and to improve productivity.
However, viewed from the risk perspective, with 27% of the index's weight spread on the top six holdings, implies a high dependency on a handful of holdings, especially considering that it held a total of 503 stocks as of November 22. This makes it more susceptible and vulnerable to downside risk, with a potential catalyst being Nvidia itself. Thus, the company came up with guidance for its fiscal fourth quarter which was above expectations thanks to pent-up demand for its advanced chips, but, nonetheless remains vulnerable to additional curbs on technology exports to China denting its topline.
JQUA's Quality Differentiator
In contrast, JQUA, despite only boasting 256 holdings (as of 11/22/2023) has less than 20% of its weight concentrated on the first ten holdings as shown below. Also, it provides instant diversification exposure to leading U.S. companies across a wide range of industries ranging from IT, Consumer Discretionary, and financial to healthcare without forgetting energy. Moreover, with nearly $2.79 billion of assets under management, and an average daily dollar volume of $25.69 million, it is a liquid fund.
Coming back to JQUA outperforming SPY in the 2022 bear market, it is because it tracks the JP Morgan U.S Quality Factor Index which aims to provide exposure to high-quality stocks while mitigating risks. As such, it employs a rule-based process to select holdings whose market capitalization ranges from $1.93 billion to $2.3 trillion (as of January 2023). Criteria used for selecting stocks are profitability, quality of earnings, and solvency together with a need to be diversified across 11 sectors on a market capitalization-weighted basis, as shown below. Additionally within each sector, each security is weighted to ensure more diversification.
Comparing sector exposure, JQUA's tech holdings account for 30.9% compared to only 29.18% for SPY, with the quality ETF excluding some big names like Amazon.com, Inc. ((AMZN)) and Tesla, Inc. ( TSLA ). Conversely, it has less exposure to Financials (only 10.2%) which may be the reason it has weathered the market turbulence caused by the March banking turmoil relatively better than SPY.
Investors will also note that there are other funds dedicated to quality like the Fidelity Quality Factor ETF ( FQAL ), or those focusing on reducing concentrated risks such as the Invesco S&P 500 Equal Weight ETF ( RSP ) based on the S&P 500 Equal Weight Index as listed in the table below.
However, FQAL has an AUM of only $342.84 million and an average daily dollar volume of just $1.4 million which means that it is relatively less liquid compared to JQUA, and, with only 133 holdings, it lacks breadth of exposure. Furthermore, it has nearly 32% of assets spread over the first top ten holdings which defeats the purpose of being less concentrated which is the very theme of this thesis. As for RSP, its equal-weighted approach has attracted interest as evidenced by its AUM of over $42 billion, and it also provides a better dividend yield too as shown in the table below.
However, the Invesco ETF comes at a higher expense ratio and does not provide the same pace of dividend growth as JQUA. For those not yet convinced about the suitability of JP Morgan's ETF, its three-year performance of nearly 33% is at least 5% above peers, which speaks for itself.
JQUA Offers Better Value at a Lower Price
Thus, in the current market setup, and for those wondering whether to add to their SPY holdings, an option is to diversify through JQUA. It also offers better value. Hence, querying for valuation multiples from Morningstar, its price to earnings of 17.84x is trading at a discount of 22% compared to SPY's 21.72x . Adjusting accordingly, I obtained a target of $55.7 (45.65 x 1.22) based on the current share price of $45.65.
Now, this constitutes a fair price given JQUA's protection against downside risks related to asset concentration. Also, regarding fees, charging only 0.03% higher than SPY, JP Morgan's ETF is reasonably cheap when considering that issuers have to factor in quality, both when selecting stocks to include but also when deciding which ones to keep in the fund over time.
Moreover, choosing this ETF avoids the hassles of analyzing individual stocks one by one, which has become harder in a stock market where the S&P 500 looks to attain new highs after the inflation rate has dropped to 3.2% from the 7% level, making it less likely for the Federal Reserve to raise rates. Also, after defying recession concerns, the American economy is forecasted to grow by 2.1% in 2024 over this year.
However, the lagging effects of sky-high interest rates still have to make their way through the economy. In this respect, it may be difficult to achieve a soft landing scenario whereby the Federal Reserve's aggressive tightening of monetary policy to keep inflation under control does not result in adverse economic impact.
In these circumstances, opting for quality makes sense.
Add Quality while being Aware of JQUA's Limits
Investors should not necessarily divest from SPY as the fund has an extremely low expense ratio of only 0.09% and, as testified by its long track record, has withstood extreme economic conditions ranging from market euphoria to recessions while delivering gains of more than 880% since its creation. On the other hand, incepted only in 2017 and with a much smaller AUM, JQUA cannot boast such a track record, something important for investors investing huge amounts of money.
Moreover, since it makes use of the Russell 1000 Index which measures the performance of the 1,000 largest companies using a rules-based approach, the ETF may miss on opportunistic gains offered by innovations like Generative AI. Also, due to its relatively lower exposure to the financial sector (compared to SPY), it could miss windfall gains related to an increase in the value of long-dated U.S. treasuries in case of the Fed loosening monetary policy earlier than expected. This would be the exact opposite of what happened during the March banking turmoil when depreciation in the value of government bonds as part of overall banks' assets created interest rate-related risks.
Even then, in view of interest rates remaining higher for longer, it is imperative to add some quality to your equity portfolio. Doing so through JQUA makes sense as it shares many names with SPY, especially the big ones. Therefore, it is like continuing to be invested in the S&P 500, but expanding this investment to include more quality and smaller caps.
Finally, the S&P 500 is highly respected as a representation of overall market sentiment but one which may have become complacent about concentration risks, thereby justifying a diversification into JQUA. This much smaller fund may not be representative of a popular passive ETF capitalizing on large caps' ability to take advantage of new opportunities, but its strict adherence to quality remains highly relevant for those who want to continue adding to their portfolio but in a less risky way.
For further details see:
JQUA ETF: Time To Add Quality To Your Portfolio Of S&P 500 Holdings