In the latest piece from Research Affiliates, Vitali Kalesnik, head of equity research, and Engin Kose, senior researcher, look at “quality” factor investing. Factor investing has rightfully gained adherents among investors seeking superior risk-adjusted returns, but their research reveals that quality is not a factor that reliably commands a premium in its own right. Nonetheless, value investing conditioned upon certain indicators of company quality is a promising strategy.
In 2000, Mike Hampton, a star pitcher, signed the largest contract in sports history up to the time. The compensation was $121 million over eight years. As it turned out, however, Hampton had only one truly successful year out of the eight. He was a great ballplayer, but he was not worth the negotiated amount. In baseball—and in soccer, too—hiring great players at high salaries is a bad business decision.
Billy Beane, the general manager of the Oakland Athletics, was one of the first major league baseball executives to understand that traditional scouting methods lead to overpaying for skills that don’t reliably contribute to success. Beane’s objective was to make the best possible use of the A’s limited salary budget by winning games as cheaply as possible.
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(His European counterpart would be Sir Alex Ferguson, who managed Manchester United from 1986 to 2013.) Beane was playing what came to be known as “moneyball.”
He and his staff learned to focus on players’ statistics, rather than appearances, and, in time, they isolated the metrics that count. In the investment field, the factor framework has migrated from academia to the real world of investment decision-making. Investors are seeking higher returns at low costs, and factor investing seems to offer the solution.
But factors may not offer the returns that many believe are linked to them. Quality is one such factor.
The meaning of quality as an investment practitioner’s term of art is unclear. It is tempting to believe that good companies— quality companies—are good investments, but the evidence does not support this thesis. Our research shows that quality is not a factor that reliably commands a premium in its own right. Nonetheless, value investing conditional on certain indicators of company quality is a promising strategy.
What Is Quality? Given the focus on factor investing as well as the allure of quality to many investors, we decided to test whether there is a reliable premium associated with a quality factor. Unlike more established factors such as market, value, or momentum, there is no precise, generally accepted definition of investment quality.