Ryan Giannotto, CFA
- The FTSE All-World Pure Quality Index neutralizes industry biases while delivering robust quality returns.
- Quality returns remain distinct from tech, with only a slight correlation of 0.046, decoupling mega-cap tech risks from quality factors.
- Negative correlation between quality and value factors enhances diversification and long-term risk efficiency.
The quality factor has been a powerful driver of returns, not only in the US equity market but on a global basis as well. The challenge with this performance premium, however, is that quality tends to skew towards a technology-heavy portfolio, exacerbating mega-cap index concentrations.
All Quality, No Tech Banaza
The FTSE All World Pure Quality Target Exposure Index is designed to maintain neutral industry and country allocations. It is part of the Single Target Factor Exposure index series, which aims to address the industry drift that is typically associated with factor exposure. If industry and country allocations are not neutralised, factor allocation often becomes simply a proxy for industry selection.
Information Technology Allocations by Index
Source: FTSE Russell Data, November 2024. Please see the end for important legal disclosures.
The target exposure methodology used in this index series allows for a precise calibration of individual risk factors, which are expressed through stock weighting tilts. Importantly, this methodology accounts for a varying intensity of factor risk to maintain a consistent risk exposure; just as market beta cycles in magnitude, so do factor risks.
We can observe this precision in action in the bar chart above: the consistently low deltas in technology allocation between the FTSE All-World Pure Quality Factor index and its underlying benchmark (the FTSE All-World Index) are remarkable. In fact, the differential averages only 12.7 basis points each year since 2008, and it is particularly striking that this precision is maintained even as the weight to the technology industry in the FTSE All-World Index swelled by 345%.
Quality and Tech: We are not a Monolith
How does systematically controlling tech exposure influence the quality return profile? As depicted below, the active returns of the Pure Quality Index and the Technology Industry Sub-Index are distinctive, and this can be interpreted even on a visual basis.
Notice, for instance, how the excess returns of Quality attenuate while those of the technology industry continue to surge after December 2022. These divergences are logical, as factors define their exposures through sensitivity to historical risk premia, while industries are defined through category of economic activity.
Active Returns of Quality and Tech Sub-Index
Source: FTSE Russell Data, November 2024. Please see the end for important legal disclosures.
These return profiles demonstrate how quality and technology are not strictly synonymous, especially when controlled for through industry allocation effects. Empirically, these differences can be measured through 150-day rolling correlations between the Pure Quality Index and the Technology Sub-Index. The blue line illustrates the co-movement of Quality and Technology over time through varying market conditions, and the linkage between risk profiles is surprisingly modest. Whereas Quality sustains an average 150-day correlation to the underlying FTSE All-World Index of 0.856, included as a control, the average correlation to the Technology Industry is only 0.736. This figure is on par with the correlation of the broad market real estate to real estate, which is typically considered a diversifying asset.
Rolling Correlations of Pure Quality to Benchmark and Technology
Source: FTSE Russell Data, November 2024. Please see the end for important legal disclosures.
Taking this analysis one step further, a multiple regression attribution of returns decomposes a very slight partial beta of the Pure Quality Index to the Technology Industry Index. This two-factor model explains 99.0% of quality returns over a twenty-year period, and yet it isolates a market independent beta of only 0.046 to technology returns.
In essence, while the relationship to technology is statistically significant, it is very slight in magnitude—a 1% rise in the technology index would imply a less than 5 basis point gain in Pure Quality, independent of market beta effects.
ANOVA Analysis
| Coefficients | Standard Error | t Stat | P-value | Lower 95% | Upper 95% | Lower 95.0% | Upper 95.0% | |
|---|---|---|---|---|---|---|---|---|
| Intercept | 1.68E-05 | 1.33E-05 | 1.264088 | 0.206253 | -9.30E-06 | 4.29E-05 | -9.30E-06 | 4.29E-05 |
| FTSE All World Index | 0.943199 | 0.00268 | 351.9476 | 0 | 0.937945 | 0.948452 | 0.937945 | 0.948452 |
| All World Technology | 0.045899 | 0.002154 | 21.30829 | 8.17E-97 | 0.041677 | 0.050122 | 0.041677 | 0.050122 |
Hence, while many technology names do score quite highly on quality characteristics, especially return on assets (“ROA”), the fundamental risk premium of quality is dissimilar to mega-cap technology risk.
Quality Controlled? Yes Indeed
Within a broader portfolio, one of the quality factor’s most robust traits is its negative correlation to the value factor. Intuitively, this behavior makes sense—investors should pay extra for companies with high, defensible margins and low debt burdens.
Monthly 10-Year Regression Quality/Value Excess Returns
Source: FTSE Russell Data, November 2024. Please see the end for important legal disclosures.
Regressing the excess monthly returns of the FTSE All World Pure Quality Index and those of its Pure Value Index counterpart over the last ten years reveals a negative correlation of -0.236. In fact, for every 1% the Pure Value Index underperforms, we would expect the Pure Quality Index to outperform by 25 basis points.
Integrating these unique drivers of risk into a comprehensive portfolio can help enhance risk efficiency expectations over the long run, as counteracting correlations are the true source of diversification. Yet more importantly, we can observe that innovative methodologies can deliver powerful quality return characteristics—without an overreliance on tech exposure. These two market mainstay risk exposures can, in fact, be decoupled.
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