Xtrackers MSCI World Quality ETF 1C GBP (LSE:XDEQ) - ETF price


ETF Report

Xtrackers MSCI World Quality UCITS ETF 1C (GBP) XDEQ

AnalystReport

PortfolioConstruction

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 ROE, 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 World 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%-65% the index value, followed by the United Kingdom (10%-15%), Hong Kong (5%-7%), and Switzerland (3%-5%). Financial services is the index’s largest sector, with a 15%-20% weighting, followed by healthcare (10%-15%) and consumer cyclical (9%-14%).

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Fees

With an ongoing charge of 0.25%, the fund is cheaper than the bulk of its category peers and is adequately priced compared with other multifactor ETFs. Index funds should provide the returns of their benchmark, less fees. However, the fund typically outperforms its benchmark. This is partly because of 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. 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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FundConstruction

The fund uses optimised sampling to replicate the performance of the MSCI World Sector Neutral Quality Index. Instead of holding all the index constituents in the same weightings, the fund holds a sample basket of securities that reflects the risk/reward characteristics of the index. While this replication method helps minimise trading costs, it can create tracking error. The fund may also hold a small amount of index futures contracts for cash management purposes. Their combined weighting is capped at 2% of the portfolio’s value, although internally the target is 1%. This ETF engages in securities lending to improve performance. Deutsche Bank Agency Securities Lending acts as the lending agent. The fund may lend out a maximum of 50% of its portfolio. As of this review, the annual maximum and average on loan levels were 4.6%, generating a net return to the fund of 0.01%. Lending transactions are fully collateralised by taking UCITS-approved quality collateral. The level of overcollateralisation varies in relation to the asset class accepted as collateral. However, it typically is 110% for equity and corporate-bond collateral, 105% for government/supranational bonds, and 100% for cash. Lending revenue is split 70/30 between the ETF and the lending agent, respectively. Xtrackers fully discloses all details pertaining to securities lending for this ETF on its website.

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Suitability

X World Quality ETF F 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 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 it began to track this index in November 2016 when compared with peers in the category, which includes actively managed funds.

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, its expense ratio is lower than more than 90% of its category peers', which gives the fund a durable advantage over the long term. On the other hand, the fund does not have a sufficient track record.

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Fundamental View

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. But 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.

It's no surprise that 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 the industrials and consumer defensive sectors.

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Alternatives

The only direct alternative to this ETF is the physically replicated iShares MSC World Quality ETF; it has an ongoing charge of 0.30%.

Other funds that favour high-quality stocks are the income-focused physically replicated iShares MSCI World Quality Dividend (ongoing charge: 0.38%) and SPDR S&P Global Dividend Aristocrats (ongoing charge: 0.45%). The former applies the same quality screens that iShares Edge MSCI World Quality ETF does, but in a sector-unconstrained framework, and it 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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AJ Bell Management Limited (company number 03948391), AJ Bell Securities Limited (company number 02723420) and AJ Bell Asset Management Limited (company number 09742568) are authorised and regulated by the Financial Conduct Authority. All companies are registered in England and Wales at 4 Exchange Quay, Salford Quays, Manchester M5 3EE. See website for full details. AJ Bell procures the provision of the Morningstar Licensed Tools on an “as is” basis and does not guarantee the performance of or accept liability for the Licensed Tools. To the maximum extent permitted by law, AJ Bell excludes liability for the Licensed Tools, including liability for any failure, interruption, delay or defect in the performance of any Licensed Tool, unless it arises as a direct result of the negligence of AJ Bell.
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