S&P Quality Indexes

This article  discusses how right now, “low quality” equities are outperforming “high quality” equities, and relates that to “risk-on” and “risk-off” cycles.  The implication here is that we are in a “risk on” market, since cyclicals and these “low quality” equities are outperforming.

What I find interesting in the article is the definition of low quality and high quality.

“One factor S&P Dow Jones indices uses in their stock classifications is an Earnings and Dividend Quality Ranking measurement. The basis for this measurement is to provide investors with a ranking that S&P evaluates based on a company’s stability of earnings and dividend over time. The highest ranking is A and the lowest is D (a company in reorganization).

With this as a background, S&P has constructed indices based on these rankings. The S&P 500 High Quality Rankings Index consists of stocks with a ranking of A and better. The S&P 500 Low Quality Rankings Index consists of stocks with a ranking of B or lower.”

Then this chart:

So, if the scale is A to D, and A is high and B-D is low, then why wouldn’t the returns average to the overall return?  Or at least include it?

Well, it turns out that the indexes do not necessarily comprise the entire S&P.  In fact, right now they only include 300 of the S&P500 stocks between them.

Not only that, but the Quality indexes are not cap weighted.  They are weighted based on the ranking.  This will invariably result in a small cap bias, and in fact might be compared to Rob Arnott’s monkey weighting.

Index methodology is so fun!


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