Portfolio Management | May 22, 2020

Even “Quality” Funds Can Be Overpriced

When market conditions grow choppy, many investors turn to high-quality funds, whose underlying stocks generally offer low debt levels, stable earnings, and strong cash flows. Although such funds tend to be less volatile than their more growth-oriented peers, rushing to quality can come at a cost.

“High-quality funds may offer some safety, but they can quickly become overpriced,” says Steve Greiner, senior vice president of Schwab Equity Ratings®. Such was the case in 2019, when investors pushed the prices of high-quality stocks—and thus the funds that track them—to their highest levels in two decades (see “Towering heights,” below).

Towering heights

Measured by their median price-to-book ratios, high-quality stocks have grown expensive relative to their lower-quality peers in recent years.

Source: Schwab Center for Financial Research. Data from 12/31/1995 through 12/31/2019. High-quality stocks are those that exhibit the strongest return on equity relative to their peers, and low-quality stocks are those that exhibit the weakest return on equity relative to their peers. Price-to-book is calculated by dividing a stock’s price by its book value per share. Book value is the net asset value of a company, and is calculated by adding up total assets and subtracting liabilities. Past performance is no guarantee of future results.
 

Be that as it may, Steve recommends having at least some exposure to high-quality funds, in part because they’re designed to deliver steadier results over time than the broader market and hence can complement the more growth-oriented parts of your portfolio. (Of course, that doesn’t mean they’re completely invulnerable to market declines. Indeed, in 2018, a handful of popular high-quality funds fell more than the overall market.1)

Searching for high-quality exchange-traded funds (ETFs) and mutual funds can prove difficult. For one, there’s no widely accepted definition of what constitutes quality. For another, quality funds are often confused with value funds—and with good reason: Both are known for their potential safety during volatile markets. Still, there are important differences:

  • Value funds favor stocks that are trading at a discount relative to their underlying fundamentals—the bigger the discount, the more prominence the stock is given in the fund.
  • Quality funds also favor stocks that are undervalued relative to their fundamental characteristics; however, they screen stocks for strong fundamentals relative to their peers—the stronger the fundamentals, the more prominent the stock.
     

Screening for funds with “quality” in the name can help narrow your hunt. When in doubt, check the prospectus to confirm a fund focuses on companies with consistent earnings, healthy cash flows, manageable debt levels, and other traits associated with quality.

1Evie Liu, “High-Quality Stocks Won’t Save You In a Risky Market. But Doing This Might,” barrons.com, 03/07/2019.

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