JQUA ETF: Where Quality Meets Simplicity (NYSEARCA:JQUA)

Investment Thesis

I first covered the JPMorgan U.S. Quality Factor ETF (NYSEARCA:JQUA) in September, finding it to be a top-performing large-cap fund with stronger quality, growth, and valuation metrics compared to the iShares Russell 1000 ETF (IWB). I also found it to deliver consistent returns, something I attribute to excellent diversification and not necessarily featured in competing ETFs like QUAL, SPHQ, and MOAT. Today, I’ll provide an update on JQUA’s performance and fundamentals against these funds and explain why I’m reiterating my buy rating. I hope you enjoy the read.

JQUA Overview

Performance: Since September And Inception

JQUA’s assets under management have increased from $2.03 in September to $3.30 billion today, a remarkable 63% increase in just four months. With a low 0.12% expense ratio and a history of outperforming in down market years like 2018 and 2022, JQUA sets itself apart from the competition by holding many well-diversified, high-quality stocks. Here is how it’s performed against IWB, QUAL, SPHQ, and MOAT since my review.

JQUA’s 10.21% total return slightly lagged QUAL’s 10.53% but outperformed the other three, including MOAT by 3.83%. This result means JQUA has overtaken MOAT on total returns since its November 2017 launch and, notably, has featured much better risk-adjusted returns, as measured by its 0.73 and 1.15 Sharpe and Sortino Ratios.

One reason I like JQUA is its potential for outperformance in bear markets. MOAT has also demonstrated this, but I’m less confident because it typically selects lower-quality stocks. MOAT has done a remarkable job selecting stocks in the right sectors at the right time, while JQUA has done well because it selects the right stocks within each sector.

I prefer JQUA’s approach because its sector allocations will always be reasonably consistent. I can easily overweight a sector with dedicated sector ETFs at any time, even using MOAT’s allocations as a guide.

Strategy Discussion and Sector Exposures

JQUA tracks the JP Morgan US Quality Factor Index, which uses a proprietary strategy to select large- and mid-cap U.S. stocks based on quality factor characteristics. The prospectus states the method “targets equity securities with higher quality characteristics relative to their sector peers as measured by profitability, earnings quality, and solvency/financial risk.”

I’ve underlined one essential part, as this differs from how other quality ETFs work. For example, if return on total capital is how you define quality, you’ll end up with a portfolio that substantially overweight Technology. Financials and Energy are where you’ll find value, Consumer Discretionary is where you’ll find growth, and Consumer Staples and Utilities typically offer the most safety. Without adequate safeguards, such as a number or total allocation of stocks per sector, the strategy is vulnerable if those sectors fall out of favor. JQUA reduces this risk with a sector-neutral approach by attempting to pick the highest-quality stocks in each sector. Investors should not worry about JQUA’s sector allocations deviating much from the Russell 1000 Index. We see this below, with the main difference being +/- 2% between Technology and Communication Services.

QUAL is similar, but it has exposure to 124 companies and 64 sub-industries compared to 244 and 92 for JQUA. With SPHQ, there are noticeable sector deviations from IWB, particularly in Consumer Discretionary, Energy, and Technology. Finally, MOAT is the most different in composition. Relative to IWB, it underweights Technology by 13% and overweight Financials and Health Care by 5% and 8%, respectively. MOAT also has potential diversification risks, holding just 49 stocks (50 regularly) across 30 sub-industries.

JQUA Top Ten Holdings

Not only is JQUA the best diversified at the sub-industry level of the four listed alternatives to IWB, but it’s also the best diversified at the company level. Its top ten holdings, shown below, total 21% of the fund. By comparison, QUAL, SPHQ, and MOAT’s top ten total 40%, 46%, and 27%, respectively.

Size matters in JQUA’s weighting methodology, as these are all household names. However, it’s likely just one of several factors. To illustrate, IWB’s top ten holdings total 30% but have only a 17% combined exposure in JQUA. There’s a 56% overlap in weight, so JQUA offers a different take on the Russell 1000 Index. And, as I’ll demonstrate next, it looks like a superior fund across the board. Let’s take a closer look.

JQUA Fundamental Analysis

The following table highlights selected fundamental metrics for JQUA’s top 25 sub-industries, totaling 73.99%. That’s 10% and 14% less than QUAL and SPHQ and about 19% less than MOAT.

Here are five observations:

1. JQUA’s five-year beta is 1.00, slightly less than the four alternatives. This statistic aligns with how JQUA has performed historically. Its historical standard deviation is lower than IWB’s, and JQUA’s maximum drawdown is about 5.5% better.

2. JQUA’s weighted average market cap is $366 billion, reflecting how it still has large-cap exposure, including to mega-caps in the Systems Software (MSFT) and Technology Hardware (AAPL) sub-industries, but just not as much as IWB. The ETF has 3.91% exposure to these $3T companies compared to 13.12%, 8.66%, 9.68%, and 1.43% for IWB, QUAL, SPHQ, and MOAT. As a holder of an S&P 500 Index ETF, I prefer the lower allocations in JQUA and MOAT for diversification purposes.

3. JQUA claims to select high-quality stocks in each sector, and its 9.42/10 profit score, which is sector-adjusted, is evidence of that claim. Only one of the listed sub-industries, Financial Exchanges & Data (SPGI, MCO, ICE, FDS, NDAQ, CBOE, MKTX), has a profit score below 9.00/10, and 195/244 stocks (91% by weight) have “A-” or better Seeking Alpha Profitability Grades. This figure is 84% in IWB, so I’m satisfied that JQUA is of higher quality.

4. QUAL and SPHQ have better profit scores of 9.68/10 and 9.88/10, respectively. However, the reason is that they hold fewer stocks. As I’ve stated in other articles, creating a fundamentally strong portfolio is easy when you don’t need to consider diversification. To illustrate, an ETF comprising the top ten Russell 1000 Index stocks by Seeking Alpha Quant Score (GOOGL, META, CRM, KO, CMCSA, CB, TWLO, S, M, TPG) would produce excellent fundamentals on paper, but 6/10 stocks are in just two sectors. A reasonable investor would not implement it. It begs the question of how many stocks are required for a well-diversified portfolio, and while IWB’s 1,000 is probably too many, MOAT’s and SPHQ’s 50 and 100 might not be enough. SPHQ is better at 125, but I’m comfortable with JQUA’s 244, especially knowing its sector exposures are consistent.

5. JQUA trades at 27.89x forward earnings, calculated on a weighted-average basis. It’s slightly cheaper than IWB and offers more estimated earnings per share growth (11.07% vs. 9.95%). A somewhat lower revenue growth rate (8.77% vs. 9.34%) is the lone weakness, primarily sourced from different exposures in the Consumer Discretionary sector. JQUA excludes Amazon (AMZN) and Tesla (TSLA), which have estimated revenue growth rates of 10.67% and 20.96%, respectively. Since these stocks appear to pass the quality and financial risk/solvency screens, I assume earnings quality is the primary reason for their exclusion. Specifically for Tesla, the company has an “F” Earnings Quality Rating from Gradient Analytics. As Scott Martindale, CEO of Sabrient Systems, the parent company of Gradient Analytics, writes:

Earnings Quality Rank is a pure accounting-based risk assessment signal that we developed together with subsidiary Gradient Analytics. Although our top-ranked (highest quality) stocks have performed well, we also have seen many of the bottom-ranked (lowest quality) stocks perform even better as speculators have bid them up. This has been particularly significant in the Energy, Consumer Non-cyclical, Financial, and Technology sectors. One glaring example is Tesla Motors.

JQUA’s methodology is proprietary, but Tesla’s exclusion makes sense if there’s any overlap with Gradient’s methodology. For your information, other high-quality stocks in IWB but not in JQUA include:

• Caterpillar (CAT)
• General Electric (GE)
• Honeywell International (HON)
• Raytheon Technologies (RTX)
• Lowe’s (LOW)
• Nike (NKE)
• The Boeing Company (BA)
• Deere & Co. (DE)
• United Parcel Service (UPS)
• CSX Corp. (CSX)

Investment Recommendation

I am reiterating my “buy” rating on JQUA. Its sector-neutral strategy and focus on quality indicate it’s likely to deliver consistent and predictable returns in excess of the Russell 1000 Index. Readers should consider alternative ETFs like QUAL and SPHQ, which also have excellent track records, and MOAT, which often features a substantially different sector mix. However, these funds have varying levels of diversification risk, and I believe JQUA is the best choice for long-term passive investors. Thank you for reading, and I look forward to your comments below.