Quality factor investing has become increasingly popular in recent years. The quality factor aims to identify stocks with strong fundamentals and earnings quality. In this article, we will illustrate how to replicate the famous Fama and French quality factor in your portfolio using quality metrics like profitability and earnings growth. We will go through factor construction, portfolio weighting, implementation issues and backtesting step-by-step to demonstrate a quality factor investing strategy example. Understanding how academic factors can be translated into investable strategies is key for investors looking to harvest these premia.
Construct quality factor using profitability and stability metrics
The most straightforward way to build a quality factor is using profitability and stability metrics. Profitability measures such as return on equity (ROE) and return on assets (ROA) identify companies generating profits from their capital. Earnings stability metrics like earnings variability look for smooth and consistent profitability. Academic studies find combining profitability and earnings stability produces the strongest quality signal. For example, the famous Fama and French quality factor uses ROA as the profitability metric and earnings stability defined as standard deviation of ROA over the previous 5 years.
Rank stocks by quality score and form factor-weighted portfolio
After calculating quality metrics for each stock, rank them by quintile based on the quality score and assign weights proportional to the score. The top quintile stocks with highest quality get the largest weights and lowest quintile with worst quality get smallest weights. This forms a quality tilted portfolio with higher exposure to high quality stocks. The portfolio can be rebalanced annually or quarterly. Factors have historically shown stronger performance at annual rebalancing frequency which addresses some trading cost concerns.
Implement long-short factor portfolio and control risks
For harvesting the quality premium, the factor is best implemented as a long-short portfolio going long top quintile high quality stocks and shorting bottom quintile low quality stocks. The dollar neutral construction controls market risk. Additional controls can be imposed for other risk exposures like industry, country, sector etc. The portfolio return captures the quality premium while removing systematic risks.
Robustness checks confirm significant quality premium
Rigorous backtesting on historical data over long time periods is key to confirm factor efficacy. Robustness checks should test different holding periods, weighting schemes, universe filters, risk controls etc. For quality, consistent significant premiums are found across regions and time using profitability and stability signals. Novy-Marx (2013) provides a detailed empirical analysis of the profitability factor. The quality effect also holds out-of-sample as a compensation for risks associated with earnings quality.
In summary, the Fama and French quality factor combining profitability and earnings stability metrics can be replicated as a long-short portfolio on highly ranked quality stocks. Robust backtesting confirms significant quality premium across regions and time. Quality factor investing provides a rules-based approach to earning quality-associated returns.