FQAL: exemplary quality, some exposure to growth, but unconvincing performance

Today I would like to provide an overdue update on the Fidelity Quality Factor ETF (NYSEARCA:FQAL), a passively managed vehicle with a strategy focused on highly profitable American indicators. The previous time I evaluated FQAL was in March 2022, when I opted for a more conservative Hold rating, mainly due to its unattractive past performance, while the excessive valuation of its portfolio, itself a consequence of interconnected size and profitability premiums, which was clearly risky in a high interest rate environment, when the Fed had just started raising rates in an effort to suppress inflationary forces, also contributed to my skepticism.

Today’s update is necessary primarily because FQAL’s portfolio has been significantly recalibrated since the previous note, or about 27% of holdings have been replaced, according to my calculations. In this regard, factor exposures have most likely changed accordingly, welcoming a reassessment with a view to a possible improvement in the rating.

As for the structure I would prefer this time around, it’s based on the questions investors considering buying into FQAL might have, including those on the factor front, the intricacies of performance and its potential for growth. ‘alpha or lack thereof.

But before we get into all that, it’s worth recapitulating the strategy. FQAL is passively managed, just like the Invesco S&P 500 Quality ETF (SPHQ), the iShares MSCI USA Quality Factor ETF (QUALITY), and the JPMorgan US Quality Factor ETF (JQUA). THE main ingredient One element of the strategy is the Fidelity US Quality Factor Index, which is rebalanced twice a year. As we can deduce from the methodological document available on the Fidelity website, the cornerstone of the index is the composite factor score, which is calculated separately for the banking sector and for the other candidates. For the first, it is twofold, with the return on equity and the debt/assets ratio being weighted equally. For the latter, it is tripartite: FCF margin, return on invested capital and FCF stability. The selection universe is made up of the 1,000 most expensive American stocks. It is important to note that the index adheres to the principle of sector neutrality.

Does FQAL meet quality expectations?

Perhaps the worst aspect of ETF factor investing is that the funds often fail to deliver on their promises. This is not the case for FQAL. It easily meets quality expectations. In terms of exposure to companies that are cash rich, extremely profitable and offer strong returns on capital, it clearly beats IVV. This is not only because among the 125 ordinary shares it held in its portfolio as of May 17, there were no loss-making companies, while IVV had around 2.5% allocated to these names . There are other, much more important considerations which will be detailed below.

First, my calculations show that FQAL’s weighted average net margin is significantly higher, at almost 27%, while IVV had 20.5%. This difference is due to the fact that the 11 GICS sectors represented in the ETF have higher average NI margins than in IVV, with the financial, IT and energy sectors being particularly strong as they have average margins of 36.4%, 31.2% and 26.6%. , respectively (19.1%, 17.6% and 16.8% in IVV), as illustrated in the table below.

Second, net income is certainly just the tip of the iceberg. My dear readers can rightly point out here that net profits are not reliable as they can be easily manipulated. This argument has merit. In this regard, we should look at other settings that are less vulnerable to it. EBITDA margin is an interesting option to use, although it has limitations as it is inapplicable to most participants in the financial sector (i.e. banks). Here again, FQAL has an advantage, offering much higher average EBITDA margins, particularly in the case of IT and healthcare.

Third, my calculations show that the median leveraged FCF margin is 17.6% for FQAL and only 10.5% for IVV.

Fourth, in terms of capital efficiency, FQAL is once again ahead. I would prefer to expand on this using adjusted return on equity and return on assets (as is). The ROE required adjustments as both portfolios are exposed to companies with overinflated numbers, primarily influenced by heavy debt, as well as companies with negative ROE that were also removed. After removing all unrealistic excesses, we see that IVV’s adjusted ROE is close to 25%, while FQAL offers 30.3%. In terms of ROA, FQAL also beat the S&P 500 ETF, with 16.8% versus 12.8%, with the IT sector being the largest contributor (an average ROA of 21.8% versus 11.1%).

Fifth, another ingredient we should definitely mention is the share of companies with a B-Quant profitability rating or higher. As of May 20, IVV had about 94.3% allocation to these names, while FQAL had about 98.7% invested in them. Additionally, no company had a profitability rating of D+ or lower in the FQAL portfolio (3.2% in IVV).

Does FQAL offer a compelling valuation story?

An inherent problem with FQAL’s strategy is that it will consistently be overweight in stocks offering premiums of significant size and quality. We should therefore obviously not expect a convincing change in valuations.

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Calculated by the author using data from Seeking Alpha, FQAL and IVV. Financial data as of May 20

As we can see from the table above, FQAL has a lower weighted average market capitalization, mainly due to its lower exposure to the trillion-dollar scale (it ignored Amazon (AMZN)). Second, the fund has a slightly higher as-is earnings yield, one reason being its exposure to companies with strong NI margins discussed above. There is no adjusted figure here because unprofitable companies are missing. However, it looks more expensive on a price/sales and EV/EBITDA basis, and its allocation to companies with a D+ or lower valuation grade is greater. In other words, in terms of valuation, FQAL is essentially close to the S&P 500, and investors looking for a better calibrated value/quality mix should look elsewhere.

Is the dosage of growth factor in the composition of FQAL shares sufficient?

I would say that FQAL’s exposure to the growth and longer duration stocks that are currently in the spotlight is quite healthy. But precisely as in the case of the value factor, as illustrated in the data below, the allocation is close to that of the IVV.

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Calculated by the author using data from Seeking Alpha, FQAL and IVV

Does FQAL have alpha potential?

Although the ETF has a factor allocation that I like, I doubt it has alpha potential. The main reason for skepticism lies in its past performance.

Created in September 2016, FQAL was unable to generate an annualized return greater than that of IVV, QUAL or SPHQ.

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Portfolio viewer data. The period is from October 2016 to April 2024

Additionally, compared to JQUA, which premiered in November 2017, it also looks rather gloomy.

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Portfolio viewer data. The period is from December 2017 to April 2024

Final Thoughts

In my previous note presented in March 2022, I called the Fidelity Quality Factor ETF a “suboptimal choice for exposure to quality factors.” This is not because the ETF was incapable of selecting highly profitable names. The problem at the time was its performance as well as its uncomfortable valuation, as a new market regime hostile to growth developed. But as conditions changed, should my rather lukewarm tone be abandoned?

Alas, I see the facts that prevent me from becoming an FQAL bull, despite his portfolio of clearly impressive quality. The main reason is that its performance is still unconvincing. That is to say, I’m skeptical that this vehicle will be able to beat the S&P 500 (and respective ETFs) consistently, even though its expense ratio was significantly reduced in 2017. November last year, from 29 basis points to 15 basis points. The Hold notation therefore remains valid.