Summary
- JQUA tracks the JPMorgan US Quality Factor Index occupied by the Russell 1000 constituents exhibiting higher quality, which is measured using a few profitability, earnings quality, and solvency/financial risk metrics.
- JQUA holdings have exemplary profitability and strong balance sheets but their valuation is not ideal.
- The ETF has outperformed IVV and IWB since its inception.
- JQUA is not an ETF for investors seeking quality and value at the same time, some compromises are clearly required. In this regard, I would opt for a Hold rating.
With a bout of bullishness taking over the markets once again and speculative names in the limelight after a year (in fact, even more than a year, in many cases rather close to even two) in oblivion, quality is not something to be forgotten simply because cooler inflation welcomes interest rate cuts in the near term. I strongly believe that financially sound, solidly profitable companies should form the very foundation of a resilient all-weather equity portfolio, and ignoring this factor could cost dearly.
Gaining exposure to grossly profitable firms via exchange-traded funds makes sense since, in the first place, they allow to reduce the potential trading costs, which would be substantially higher in the case of a theoretical DIY portfolio, while also ensuring adequate diversification. The JPMorgan U.S. Quality Factor ETF ( JQUA ) is amongst the options to consider for a few reasons. First, it has paper-thin fees of only 12 bps which places it ahead of key competitors like the iShares MSCI USA Quality Factor ETF ( QUAL ) and Invesco S&P 500 Quality ETF ( SPHQ ) that both have expense ratios of 15 bps. Second, it has outperformed the iShares Core S&P 500 ETF ( IVV ) and iShares Russell 1000 ETF ( IWB ) since its inception, with a lower standard deviation and uncoincidentally higher Sharpe and Sortino ratios (hence, higher risk-adjusted returns). Third, partly owing to the weighting schema, it has a meaningfully lower weighted-average market capitalization compared to IVV and its peers, so investors seeking to reduce dependence on the $1 trillion league might find this low-cost ETF especially appealing. However, a suggestion that JQUA is completely faultless would be a preposterous one as there is always something to dislike about any ETF. I will elaborate on that shortly.
Investment strategy overview
JQUA tracks the JP Morgan US Quality Factor Index, which is occupied by the Russell 1000 constituents exhibiting higher quality measured using a few profitability, earnings quality, and solvency/financial risk metrics, ten in total, including Return on Equity, Free Cash Flow/Sales, Cash Flow/Total Debt, change in accruals, etc. The index is supposed to mirror sector allocations of its selection universe and is reviewed on a quarterly basis. More details on the methodology including the full list of metrics with definitions used can be found in the respective documents on the FTSE Russell website .
What is inside the portfolio
The result of this highly sophisticated approach involving analysis of complex profitability and financial position indicators is a portfolio of 244 holdings (including cash and futures), with the cohort of key ten having a weight of 18.4%. As the underlying index is supposed to have sector weights similar to the Russell 1000, IWB and JQUA have only measly differences in allocations as can be seen below; QUAL which also adheres to the principles of sector neutrality was added for better context.
GICS sector weights (Created by the author using data from Seeking Alpha and the funds)
Delving deeper, the profitability characteristics of JQUA's holdings in most cases are close to exemplary. For example, only 2.9% have negative LTM accounting earnings, while the weighted-average net margin at around 15.2%, as per my calculations; none (obviously excluding the financial sector) is cash-burning. Besides, about 74% have Total Debt/EBITDA below 3x. It is also worth noting that about 81.5% of the holdings have an A (+/-) Seeking Alpha Quant Profitability grade.
Visa ( V ), a bellwether payments technology company, accounting for about 2%, is the largest holding at the moment. Answering the question about why V has qualified for this portfolio, I could unhesitantly point to its A+ Quant Profitability grade undergirded by a phenomenal EBITDA margin of around 70.4%, ~21% Return on Total Capital, and a few other metrics being grossly above the sector medians thanks to its business model securing wide economic moat. V has a Total debt/EBITDA of 1.1x also as a consequence of its leading position in the industry since it supports higher margins that in turn translate into higher FCF which could be reinjected back into the business, thus dependence on debt investors' funds is markedly lower. Please pay attention to the fact that according to FTSE Russell's Industry Classification Benchmark, V is an industrial company while in the GICS, it belongs in the IT sector.
At the same time, only three out of four $1 trillion league members Apple ( AAPL ), Microsoft ( MSFT ), and Alphabet ( GOOGL ) are present, yet with weights drastically cut compared to IVV and iShares Russell 1000 ETF ( IWB ). However, JQUA holds neither Tesla ( TSLA ) nor Amazon ( AMZN ); it seems these two major S&P 500 players appeared to be not profitable or financially resilient enough for this elite cohort, which, I suppose, might look a bit counterintuitive since both have an A+ Quant Profitability grade.
Seeking Alpha
The table below with a few select profitability, valuation, and performance metrics for the ten key holdings should better contextualize what types of stocks JQUA favors.
Created by the author using data from Seeking Alpha and the fund
Something to dislike: robust quality comes with a premium valuation
Premium valuation is something investors who are pondering an option to test the quality strategy with JQUA would have to tolerate. Alas, this is almost completely unavoidable as composing a portfolio of grossly profitable large-size U.S. equities requires some compromises.
As I have already said above, JQUA has a WA market cap meaningfully lower compared to IVV, around $243 billion, to be precise. Unfortunately, this did not contribute to a better valuation. For example, its earnings yield is only about 5% (backed by a forward EPS growth rate of 15.2%), as of my calculations, which is on par with IVV. Meanwhile, 63.6% of the holdings are priced at a premium to their sectors which is illustrated by a D+ Quant Valuation grade and lower; just around 12% are underappreciated (B- and better).
Final thoughts
Incepted on 8 November 2017, during the December 2017 - December 2022 period, JQUA delivered an almost 11% compound annual growth rate vs. IVV's 9.46%, principally thanks to especially strong 2022 when it beat the S&P 500 ETF by close to 5%. It also outperformed IWB, and strongly. At the same time, both QUAL and SPHQ were meaningfully behind during that period, with lower CAGRs and higher standard deviations. JQUA's maximum drawdown shown below is also telling.
Portfolio | JQUA | IVV | QUAL | IWB | SPHQ |
Initial Balance | $10,000 | $10,000 | $10,000 | $10,000 | $10,000 |
Final Balance | $16,990 | $15,834 | $15,102 | $15,559 | $15,800 |
CAGR | 10.99% | 9.46% | 8.45% | 9.09% | 9.42% |
Stdev | 17.46% | 18.49% | 19.09% | 18.78% | 17.79% |
Best Year | 28.67% | 31.25% | 33.89% | 31.06% | 33.29% |
Worst Year | -13.46% | -18.16% | -20.49% | -19.19% | -15.77% |
Max. Drawdown | -22.15% | -23.93% | -27.78% | -24.57% | -24.33% |
Sharpe Ratio | 0.61 | 0.51 | 0.45 | 0.49 | 0.52 |
Sortino Ratio | 0.94 | 0.76 | 0.67 | 0.72 | 0.79 |
Market Correlation | 0.97 | 1 | 0.98 | 1 | 0.97 |
Created using data from Portfolio Visualizer
However, in 2023, for now, the ETF is performing a bit softer compared to its counterparts and the market.
To sum up, JQUA is a low-cost fund with a solid track record, heavy in U.S. top-quality bellwethers, yet its earnings yield is only modest, even though the weighted-average market cap is almost 2x lower compared to IVV. JQUA is not an ETF for investors seeking quality and value at the same time, some compromises are clearly required. In this regard, I would opt for a Hold rating, with a remark that investors who are looking for a substitution for QUAL or SPHQ should take a closer look at this ETF.
For further details see:
JQUA: This Quality-Centered Outperformer Deserves Attention