New quality indices from MSCI

“Quality” is clearly a popular theme among nervous equity investors at the moment, so it’s not surprising to see that MSCI has just launched a series of quality indices. The press release [PDF] and methodology [PDF] give more details, but essentially the components are screened on three factors: High return on equity, stable earnings and low financial leverage.

This is what most investors would consider to be a simple standard definition of quality, as opposed to the two obvious comparison indices: Société Générale’s new-ish Global Quality Income Index (which is a somewhat more complicated combination of the Piotroski score and the Merton distance-to-default model) and the older Standard and Poor’s S&P 500 High Quality Rankings Index, which is based on stability and growth of earnings and dividends (and in my view doesn’t seems to provide a very satisfactory quality filter).


Low volatility and high quality

Low Risk Stocks Outperform within All Observable Markets of the World is an interesting paper from earlier this year that I’ve belatedly got round to reading. Co-written by Robert Haugen, one of the pioneering figures in quantitative investing, it focuses on the low volatility anomaly, which is the evidence that low volatility stocks on average produce higher returns than high volatility ones

The low volatility anomaly goes against conventional financial theory, which states that more volatile stocks should outperform since they are riskier. Haugen was one of the first researchers to show decades ago that empirical data in the USA did not support this idea and data in this newer paper essentially updates that. It looks at 21 developed markets and 12 emerging markets since 1990 and shows that low volatility stocks have consistently outperformed in all of these.

Of course, the interesting question is why this anomaly persists. Haugen and his co-author Nardin Baker propose what is essentially a behavioural and agency-based explanation, revolving around perceived incentives for the investment management industry to favour more volatile stocks.


Why Quality Investing works

Dylan Grice, the ever-interesting strategist at Société Générale, put out a good note recently arguing that quality investing outperforms. In other words, buying safer stocks leads to higher returns on average.

This is not what conventional investment thinking says. The standard rule of thumb is that risk and return are positively correlated. Getting higher returns means taking on more risk.

Taken over the long run, that holds true across assets. The data shows that higher risk asset classes have delivered higher returns over time. The chart below shows long-term returns for US asset classes (chart is via Grice’s note, data taken from Expected Returns by Antti Ilmanen).