2023-06-29 13:30:00 ET
Summary
- We are reviewing Invesco S&P 500 Quality ETF, highlighting its construction, performance, and potential risks. This ETF tracks high-quality stocks from the S&P 500 and has outperformed the S&P 500 in total returns with less volatility over a 12-year period.
- Despite its performance, we are concerned about the heavy concentration in the technology sector and its top holdings in Nvidia and Apple, which could lead to potential volatility.
- The ETF also exhibits concentration risk at both the sector and holding levels, with 44.52% of the fund concentrated in its Top 10 holdings.
- While SPHQ is interesting, with a good track record, its recent outperformance could be a mirage due to strong performance of its top holdings. Investors might be better off adding to the Schwab U.S. Dividend Equity ETF, given its underperformance in 2023.
(This article was co-produced with Hoya Capital Real Estate.)
Earlier this month, I reviewed iShares MSCI USA Quality Factor ETF ( QUAL ). My conclusion was that it was an interesting case of high quality but mixed results .
For this review, I decided to take a look at another option investors may wish to consider if interested in the high-quality segment of the market. This option is Invesco S&P 500 Quality ETF ( SPHQ ). Interestingly, I found this particular ETF a little more intriguing than QUAL.
In this article, I will first dig into some of the particulars about this ETF. We will examine the construction of the underlying index it tracks, as well as some of the pros and cons of this approach. Next, we will examine SPHQ's historical performance as well as my current outlook.
Invesco S&P 500 Quality ETF: Digging In
From a quality standpoint, and similar to QUAL, there is much to like about this ETF. Certainly, it is worthy of consideration as an element of one's portfolio.
In terms of longevity and track record, with an inception date of 12/6/05, SPHQ has been around roughly 7-1/2 years longer than QUAL. According to Seeking Alpha's home page for SPHQ , it currently boasts an AUM of $5.29 billion. It carries an expense ratio of .15% and a modest trading spread of .02%. Both of these are comparable to QUAL.
The fund tracks the S&P 500 Quality Index , which sweeps in high-quality stocks from the S&P 500. Here, from the fact sheet provided by S&P Indices, is some breakdown of the construction of the index. Starting with the universe of stocks contained in the S&P 500, the index selects 100 companies for inclusion, ranked by the following 3 criteria:
- Return on equity : Calculated as the companies' trailing 12 months earnings per share divided by the companies' latest book value per share.
- Accruals ratio : Computed using the change of the companies' net operating assets over the last year divided by the companies' average net operating assets over the last two years.
- Financial leverage : Calculated as the companies' latest total debt divided by the companies' book value.
These three scores are then combined into one single metric which is then used to rank the constituents. Next, each constituent's overall weighting in the fund is derived by combining this quality score with the float-adjusted market cap. As a result, each constituent's weight is a very interesting mix of its quality score combined with its actual market cap .
Finally, the index implements several weighting constraints, including limitations on both the minimum and maximum weights that any one stock can hold in the portfolio, as well as a limitation that no sector can account for more than 40% of the portfolio.
As can be seen, then, S&P’s quality score favors more-profitable companies while trying to steer clear of those that rely on debt financing or have been aggressively growing their assets. As a result, the companies featured in its lineup tend to be established businesses with strong and stable cash flows.
In the excellent graphic below, from Seeking Alpha's landing page for SPHQ linked earlier in the article, let's see how this plays out in real life.
Here, though, is a potential downside. As you peruse the list of Top 10 holdings in the graphic above, you will see a very interesting mix of companies. At the same time, the fund exhibits a measure of concentration risk at both the sector and holding level, with those two sectors comprising almost 51% of the fund. At the holding level, we find some 44.52% of the fund concentrated in just the Top 10 holdings. All of this despite caps on individual positions meant to promote diversification. In both respects, SPHQ is slightly more concentrated than QUAL.
SPHQ's Performance - Beating The S&P 500
Similar to what I did with QUAL, I performed a backtest using Vanguard S&P 500 ETF ( VOO ) and Schwab U.S. Dividend Equity ETF ( SCHD ) as comparison points. While neither represent perfect apples-to-apples comparisons, VOO tracks the entire S&P 500 at a rock-bottom .03% expense ratio and SCHD offers what many investors have come to accept as the gold standard of quality filters at an expense ratio of .06%.
In the backtest, I was able to go back as far as November, 2011, with SCHD's inception date being the limiting factor. Have a look at the results and then I will share a few of my observations, along with a couple of surprises.
Here is my key observation, and the one that came as a pleasant surprise. Over this period of almost 12 years, SPHQ's particular filtering criteria has produced superior risk/reward results to the overall S&P 500. As can be seen from the above results, SPHQ managed to slightly beat the S&P 500 in terms of total return. Even better, it managed to do so with less overall volatility. For investors, this is always a desirable combination.
What might this tell us about SPHQ? Here are some potential benefits that make it an attractive option for investors seeking quality exposure:
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Downside Protection: The focus on quality companies with robust financials and competitive advantages can provide a measure of downside protection during market downturns. This defensive aspect may be particularly appealing to risk-averse investors looking to weather uncertain market conditions.
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Risk-Adjusted Returns: By targeting quality stocks, SPHQ seeks to generate attractive risk-adjusted returns over the long term. This approach aligns with the belief that quality companies can outperform during various market cycles, leading to potential alpha generation.
Here, though, was the other surprise. Over this extended time period, SPHQ fairly easily outdistanced the performance of SCHD. You may recall that SCHD's inception date was the limiting factor in how far the backtest was able to extend, so this represents the entire history of SCHD.
But here is where this comparison gets a little nuanced. I found that if I simply truncated the end date of the backtest to the end of last year, SCHD had actually trounced both VOO and SPHQ.
In other words, there has been a huge discrepancy so far in 2023. Here's what this appears to say to me. Similar to QUAL, NVIDIA ( NVDA ) has recently leapfrogged everything else to become the top holding in SPHQ. And Apple ( AAPL ) is not far behind. Of course, both of these stocks have been absolutely stellar performers of late, at some level dragging the entire market up along with them. And so, both SPHQ as well as VOO look quite good at the precise point in time at which this article is written.
In contrast, with its meager 12.19% weighting in the technology sector—and not a single share of NVDA or AAPL anywhere to be found—SCHD has notably underperformed in 2023. Even here, then, SPHQ's recent outperformance could turn out to be somewhat of a mirage, and the long-term advantages of SCHD could return to the fore.
Summary and Conclusion
Putting it all together, then, SPHQ is certainly an interesting ETF.
Over the roughly 12 years of my analysis, I can't find anything bad to say about an ETF that beat the S&P both in terms of total returns but, even more impressively, with a better risk/reward profile.
At the same time, I am concerned that SPHQ's heavy weighting in the technology sector, and the fact that NVDA and AAPL are its top 2 holdings, may lead to some volatility ahead. As badly as SCHD has performed in 2023, you might actually be better off adding to this ETF right now.
I hope this review has proved useful to you in making your personal decision. Please, drop a note in the comments section letting me know what you think of my analysis.
For further details see:
SPHQ: Strong Risk/Reward Ratio Beats The S&P 500