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CMCRC research examining US equities shows that Quality stocks, and mutual funds which invest in these Quality stocks, provide downside protection during financial market crises. Given the market volatility associated with the Global Financial Crisis (GFC), the market has paid increasing attention to the quality of assets managed by professional investors and the use of fundamental analysis to assess these investments. The “flight-to-quality” phenomenon is particularly prevalent during times of market stress. When the economy shows signs of weakening, conventional wisdom suggests that investors might benefit if they focus on larger companies with robust/solid businesses that are more likely to survive the rough times or market volatility. In 2006 a Wall Street Journal article indicated that “by moving your assets toward high-quality, less-risky issues, you can potentially save investment money if the market goes into a downturn”. A recent US study by Camille Schmidt, Peter Gardner and Professors David Gallagher and Terry Walter examines the link between the quality of assets held by mutual funds and fund performance. Quality is measured using a Q-Score which is the composite of 14 accounting metrics selected based on their merits as indicators of a sound investment. The Q-Score developed explains a greater proportion of future earnings and stock returns than existing measures. In the portfolio management industry, professional consulting firms now scrutinise the dimensions of portfolio holdings of fund managers, and report these attributes to trustees of pension funds. This implies that fund attributes are an important consideration in the assessment of funds by current and potential investors. Hence, their research work advocates that it is important to study the quality attributes of mutual funds. The CMCRC’s research shows that the lowest quality stocks perform very poorly on average. Furthermore, there is a positive relationship between stock size and quality, while volatility is inversely related to quality. Interestingly, the overall level of quality of the stocks selected by funds has increased over time. Moreover, the funds which hold the lowest quality stocks exhibit significant underperformance. The downside protection offered by quality stocks in stressful market conditions is also evident. For example, during the time of the GFC the highest quality funds significantly outperformed the lowest quality funds by 115 basis points per month. This result is consistent with the flight-to-quality phenomenon mentioned above. Funds which hold the lowest quality stocks also have higher turnover and expenses, and are also slightly younger on average.
Author(s): David R. Gallagher, Peter A. Gardner, Camille H. Schmidt, Terry S. Walter
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