The fund employs optimised replication to track the MSCI World Sector Neutral Quality Index, which selects stocks with high profitability, strong balance sheets, and stable earnings growth from the MSCI World Index. The resulting portfolio favours firms with durable competitive advantages that should hold up a little better than average during market downturns, warranting a Positive Process Pillar rating.
The index screens for stocks with high returns on equity, low debt/equity, and low volatility of year-over-year per-share earnings growth during the past five years. MSCI assigns a sector-relative composite quality score to each stock in the MSCI World Index based on these three metrics. It then selects the top-scoring stocks within each sector and sets its sector weightings equal to those of the MSCI Europe Index on each rebalancing date. Stocks with higher sector relative quality scores and market caps receive larger weightings in the index. However, the index adjusts these weightings to maintain sector neutrality. This adjustment may slightly reduce the portfolio's quality tilt and increase turnover. But the fund applies buffer rules to mitigate unnecessary turnover. MSCI reconstitutes the index twice a year in May and November.
The United States accounts for approximately 60% to 65% the index value, followed by the United Kingdom (10%-15%), Hong Kong (5%-7%), and Switzerland (3%-5%). The index's largest sector is financial services, with a 15%-20% weighting, followed by healthcare (10%-15%) and consumer cyclical (9%-14%).
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With an ongoing charge of 0.30%, the fund is cheaper than the bulk of its category peers and is adequately priced compared with other multifactor exchange-traded funds.
Index funds should provide the returns of their benchmark, less fees. However, the fund typically outperforms its benchmark. This is partly due to the quality of portfolio optimisation. But it can also be attributed to the fact that the fund is domiciled in Ireland and benefits from a lower dividend-withholding tax rate on US stocks than the one used for index calculations. Besides, the fund also benefits from securities-lending revenues.
The fund's annualised tracking error has been relatively low. Tracking error is a measure of how consistently a fund tracks its benchmark index. The closer the tracking error is to zero, the better or more efficient the fund is.
Investors should also consider trading costs, including bid-ask spreads and brokerage fees, when buying and selling the ETF.
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IShares uses a physical optimised approach to replicate the performance of the MSCI World Quality Sector Neutral Net Return Index. Instead of holding all the index's constituents in the same weightings, the fund holds a sample basket of securities that reflects the return and risk characteristics of the index. While this replication method helps minimise trading costs, it can create tracking error. The fund uses futures for cash management purposes. This is standard practice and helps limit tracking error.
IShares engages in securities lending and can lend up to 100% of the securities within the fund to improve its performance. The gross revenue generated from this activity is split 62.5/37.5 between the fund and the lending agent BlackRock, whereby BlackRock covers the costs involved. The fund lent out 6% on average, generated 0.01% net income, and had 9.7% of the portfolio maximum on loan over the past 12 months ended December 2018. To protect the fund from a borrower's default, BlackRock takes collateral greater than the loan value. Collateral levels vary between 102.5% and 112% of the value of the securities on loan, depending on the assets provided by the borrower as collateral. Additional counterparty risk-mitigation measures include borrower default indemnification. Specifically, BlackRock commits to replace the securities that a borrower would fail to return. The indemnification agreement is subject to changes, in some cases without notice.
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IShares Edge MSCI World Quality Factor ETF is a great low-cost index strategy that should hold up a little better than the market and most of its peers during downturns. While it probably won't beat the market in strong rallies, it should offer better risk-adjusted performance over the long term, supporting a Morningstar Analyst Rating of Bronze.
The fund targets large- and mid-cap global developed stocks with the best profitability (measured by return on equity), strongest balance sheets, and most consistent earnings growth within each sector. These stocks often carry above-average valuations, and, because the fund does not impose a valuation discipline, it tends to exhibit a growth tilt.
The strategy's sector-relative stock-selection approach facilitates peer-to-peer comparison, but it can cause the fund to own stocks with lower absolute quality characteristics than it otherwise would. To further mitigate unintended sector bets, the fund matches its sector weightings to the broad market-cap-weighted MSCI World Index's. This adjustment can increase turnover, though turnover here is typically below the global large-cap blend Morningstar Category average. Within each sector, the fund weights its holdings according to both the strength of their quality characteristics and their market cap. This pulls the fund toward stocks with durable competitive advantages, such as Microsoft, Apple, and Johnson & Johnson.
The fund has delivered above-average risk-adjusted performance since its inception in October 2014 when compared with peers in the category, which includes actively managed funds.
To conclude, we have a positive view of the strategy as defined by the MSCI World Sector Neutral Quality Index, as it captures higher-quality stocks in a well-controlled risk framework. Moreover, expense ratio is lower than over 90% of its category peers, which gives the fund a durable advantage over the long term. On the other side, the fund does not have a sufficient track record.
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Stocks with higher profitability and other measures of quality have historically offered higher returns than their less-profitable and lower-quality counterparts in most markets studied. It is tough to square quality stocks' strong historical performance with their seemingly attractive characteristics and below-average risk profile. One possible explanation is that investors may not have fully appreciated the long-term sustainability of these firms' profits and undervalued them. However, that may not always be the case. Valuations matter, and quality stocks are not necessarily good investments at any price. Not surprisingly, the relationship between profitability and future stock returns is stronger after controlling for differences in valuations. Because this fund does not take valuations into account, it is important to check the valuations of its holdings before buying.
Many investors are drawn to lower-quality stocks because they tend to offer greater upside potential than their higher-quality counterparts. This could help explain how these stocks become less attractively valued and priced to offer lower returns on average. The fund's holdings are unlikely to offer eye-popping returns, particularly during market rallies. But it should reward patient investors with a better risk/reward profile than the broader market over the long term.
Not surprisingly, the fund's holdings look much more profitable than the constituents of the broad MSCI World Index, largely because of the inclusion of return on equity in its selection criteria. Most of the portfolio is invested in stocks with sustainable competitive advantages that should allow these attractive profits to persist. The fund's inclusion of low financial leverage in its selection criteria penalises companies that generate high return on equity through debt financing and reduces exposure to financial risk. It also indirectly tilts the portfolio toward more-profitable firms, which tend to be less dependent on debt.
Earnings growth consistency helps paint a more complete picture of the strength of each business. The fund measures this dimension of quality with per-share earnings-growth variability over the past five years. This leads the fund to firms on stable growth trajectories, which tend to be less volatile than more-erratic growth companies.
The fund's sector-relative focus facilitates direct peer-to-peer comparisons, which should lead it to the highest-quality names in each sector, helping it avoid persistent sector biases. This approach gives it greater exposure to the financial services, healthcare, and technology sectors at the expense of industrials and consumer defensive.
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The only direct alternative to this ETF is the physically replicated Xtrackers MSCI World Quality ETF, which has an ongoing charge of 0.25%.
Other funds that favour high-quality stocks are the income-focused physically replicated iShares MSCI World Quality Dividend (0.38% ongoing charge) and SPDR S&P Global Dividend Aristocrats (0.45%). The former applies the same quality screens that the iShares Edge MSCI World Quality Factor ETF does, but it uses a sector unconstrained framework and takes into consideration the stocks' dividend yields in its weighting scheme. The SPDR ETF includes only the highest-yielding companies that have maintained or raised their dividends for at least 10 years and weights them by dividend yield. Although it does not screen for quality companies explicitly, the stringent criteria result in a portfolio with a consistently higher-quality tilt than its category peers.
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