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Quality: The Parallels Between Investing And Dieting

February 19, 2020
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Investing has many parallels to dieting. While junk food may taste delicious in the moment, too much of it can come back to bite you. On the other hand, nutritious food may not always be as satisfying in the moment, but it’s better for you over the long-term. The recent growth of plant-forward diets exemplifies this in the food world as people look for healthier solutions without aggressively trying to limit caloric intake, which may be hard to do sustainably.

While we are not nutritionists, most people would agree that junk food should be eaten in moderation and the same can be applied when it comes to investing. It can be exciting to purchase a stock with a great story, but if it lacks robust fundamentals, it may ultimately not pay off as one would hope, which is one of the drivers why investors have flocked   to strategies with defensive postures, such as high quality and low volatility stocks, to bolster portfolios even during a tremendous bull market.

Quality Satisfies

  • Research from both academics and the investment community indicates that a portfolio of high quality stocks has a high correlation with low volatility stocks. So, while investors may be tempted by recent market wobbles to shift their portfolios toward low volatility stocks, moving up in quality may be more appropriate considering the macro environment remains supportive for risk assets outside of the recent pullbacks related to concerns around the impact that the coronavirus may have on near-term sentiment.
  • Performance over the last twelve months provides insight into this with high quality outperforming low volatility stocks when the S&P 500® is rising, but underperforming when markets are falling suggesting that quality offers better upside participation than low volatility stocks, even if low volatility have been superior on the downside. Interestingly, both approaches ended at roughly similar places, but their path differed, highlighting the fact that quality should be considered distinct relative to low volatility and is deserving of investor attention as a means to bolster equity portfolios in times of uncertainty.

High Quality Stocks And Low Volatility Stocks Have Ebbed And Flowed Over The Last Year
Source: Bloomberg Finance, L.P., as of January 31, 2020. High Quality represented by the S&P 500® Quality Index and Low Volatility represented by the S&P 500® Low Volatility Index. Past performance is not indicative of future results. One cannot invest directly in an index.

What Is “Quality”?

Low volatility is a relatively simple concept to understand as it uses returns as its primary input, but investing based on measures of quality may be more nuanced, just as limiting one’s calorie intake may be easier to grasp than integrating healthier habits. However, it may not generate the intended long-term effect. So, what exactly is quality?

  • One can think about quality across three groups: profitability, earnings cleanliness and balance sheet health measured by return on equity (ROE), accruals ratio, and debt to equity. Each of these captures different pillars of corporate fundamentals that help to create a balanced view of firms’ productivity, the potential for accounting red flags, and   prudent and efficient capital structure. In aggregate, these metrics show whether companies are competitively positioned and more solvent than peers, which would give them advantages in all operating environments, especially the more difficult ones like economic slowdowns and recessions.
  • The below figure illustrates this for the return on equity and debt to equity ratios across the 100 highest quality stocks   in the S&P 500®, the 100 lowest quality stocks, and the S&P 500®. As one would hope high quality have a considerable higher ROE and much lower debt to equity than the broader market. On the flip side, low quality stocks, even those in the S&P 500®, have low profitability and high leverage furthering the point that high quality names are likely better able to handle economic slowdowns and have favorable competitive positions, all else being equal.

High Quality Companies Have High Profitability And Low Financial Leverage

Source: Bloomberg Finance, L.P. as of January 31, 2020. High Quality represented by the S&P 500 Quality Index and Low Quality represented by the S&P 500 Quality – Lowest Quintile Index. Past performance is not indicative of future returns. One cannot invest directly in an index.

Implementation Ideas

  • The Direxion S&P 500 High minus Low Quality ETF (QMJ) takes quality investing a step further then has been previously available to investors as it is the only ETF that offers investors long exposure to high quality stocks with short exposure to low quality stocks packaged in a capital efficient 150/50 structure.

Definitions

  • S&P 500 Quality Index: The S&P 500® Quality Index is designed to track high quality stocks in the S&P 500 by quality score, which is calculated based on return on equity, accruals ratio and financial leverage ratio.
  • S&P 500 Quality: Lowest Quintile Index: The S&P 500® Quality – Lowest Quintile Index is designed to measure the performance of the 100 lowest-ranked stocks in the S&P 500 based on quality score. Quality scores are calculated based on return on equity, accruals ratio, and financial leverage ratio.
  • S&P 500 Low Volatility Index: The S&P 500® Low Volatility Index measures performance of the 100 least volatile stocks in the S&P 500. The index benchmarks low volatility or low variance strategies for the U.S. stock market. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.
  • S&P 500 Index: Standard & Poor’s® selects the stocks comprising the S&P 500® Index on the basis of market capitalization, financial viability of the company and the public float, liquidity and price of a company’s shares outstanding. The Index is a float-adjusted, market capitalization-weighted index.

An investor should carefully consider a Fund’s investment objective, risks, charges, and expenses before investing. A Fund’s prospectus and summary prospectus contain this and other information about the Direxion Shares. To obtain a Fund’s prospectus and summary prospectus call 866-476-7523 or visit our website at direxion.com. A Fund’s prospectus and summary prospectus should be read carefully before investing.

Shares of the Direxion Shares are bought and sold at market price (not NAV) and are not individually redeemed from a Fund. Market Price returns are based upon the midpoint of the bid/ask spread at 4:00 pm EST (when NAV is normally calculated) and do not represent the returns you would receive if you traded shares at other times. Brokerage commissions will reduce returns. Fund returns assume that dividends and capital gains distributions have been reinvested in the Fund at NAV. Some performance results reflect expense reimbursements or recoupments and fee waivers in effect during certain periods shown. Absent these reimbursements or recoupments and fee waivers, results would have been less favorable.

Direxion Shares Risks - Investing involves risk including possible loss of principal. The Fund’s investment in derivatives may pose risks in addition to, and greater than, those associated with directly investing in or shorting securities or other investments. There is no guarantee that the investment strategy will be successful in identifying high and low quality stocks. Many factors can affect a stock’s quality and performance, and the impact of these factors on a stock or its price can be difficult to predict. Quality stocks may underperform while non-quality stocks may perform well. There is no guarantee that the returns on the Fund’s long or short positions will produce positive returns, and the Fund could lose money on either or both Fund’s long and short positions. Please see the summary and full prospectuses for a more complete description of these and other risks of the Fund.

Distributor: Foreside Fund Services, LLC.

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