Summary Berkshire Hathaway may be a model for a quality company and merits a place in one’s portfolio on that basis. Berkshire Hathaway’s recent performance has been disappointing. Can an ETF focused on the quality factor replace it and improve returns as well as portfolio quality? I continue to review my holdings with an eye to what I want to keep and what’s not earning its keep. After a hard look, I decided Berkshire Hathaway (NYSE: BRK.B ) just wasn’t getting it done. Take a look at some stats for BRK.B and the ETFs tracking the S&P 500 and the NASDAQ 100. Annualized Volatility Beta Daily Value at Risk Max Drawdown Total Return (1 year) BRK.B 14.2% 0.91 2.1% -6.3% 4.4% SPDR S&P 500 Trust ETF ( SPY) 12.7% 1.00 1.9% -4.9% 9.5% PowerShares QQQ Trust ETF ( QQQ) 13.7% 0.99 2.0% -5.7% 11.8% Looking at these numbers, I asked myself “Why?” Why do I need something that I think of as high-quality but ultraconservative yet has greater volatility than the NASDAQ 100. And with that volatility comes barely a third QQQ’s return. It has greater volatility than the S&P 500 as well, and half of SPY’s return. Sure, the stock has had great years in the past, but when I ask what it’s done for me lately, I’m not getting an answer that tells me to hold onto it, especially since it’s a large holding for me. The question was, what do I replace it with? In looking for the answer, I asked myself why I was holding BRK.B. What came immediately to mind? Quality. When I bought the stock it was because I viewed it as the model for quality. So, while I was deciding to part ways with BRK, I had to decide how to fill the gap it would leave. I might have begun by considering other stocks, of course. But, another factor that entered into my thinking is that I have been moving away from individual stock holdings in favor of funds. That decision is the subject of another discussion altogether, but especially for places where a stock is occupying a structural role in my portfolio, I think it can make more sense to fill that slot with an ETF that does the same job. So, what I wanted was a fund that emphasized high-quality. What Asness et al., following the Fama-French factor terminology, called Quality Minus Junk in their 2013 paper on the subject. In that paper they define quality stocks as being “safe, profitable, growing, and well managed” and showed how the quality factor has outperformed. After BRK.B had a nice pop on Thursday and Friday, I decided it was time. I could have gone with one of AQR’s mutual funds, which are built on Asness’s rigorous research. But, even if the door was open to me, I’m not in a position to fork out the cost of entry. These funds have a nominal minimum purchase of $1-5 Million depending on share type. I have a large holding in BRK.B but not remotely that large. In addition there are fees that approach 2%, and the funds are generally available only through advisors. I’m sure you can get in for less than that nominal seven-figure requirement if your timing and brokerage are right. In fact I do hold an AQR mutual fund purchased this way despite its nominal $1M minimum. But most of them are closed to new or even current investors. A smart move by the funds’ management, keeping the funds something halfway between an open-end and closed-end mutual fund. I won’t argue the desirability of AQR mutual funds, but as I go through them, I don’t see enough to justify those barriers to me. What I went for was the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ), which does what it says on the label: Emphasizes the quality factor. QUAL: Top Ten Holdings and Sector Distribution When I start to look at an ETF almost the first thing I do is look at the portfolio. (click to enlarge) I found that the top six positions in QUAL were also in my own portfolio: Microsoft (NASDAQ: MSFT ), Johnson & Johnson (NYSE: JNJ ), Apple (NASDAQ: AAPL ), Gilead (NASDAQ: GILD ), Berkshire Hathaway and Costco (NASDAQ: COST ). Four more of my stocks were in the top 20: Celgene (NASDAQ: CELG ), AT&T (NYSE: T ), Chevron (NYSE: CVX ) and Qualcom (NASDAQ: QCOM ). I hold a total of 14 individual stocks, and I look primarily for quality in my choices. So, I was struck by the convergence of my opinion and that of QUAL’s passive algorithm. I’m not sure I’ve ever looked at an ETF portfolio and found 70% of my portfolio’s stocks in the ETF’s top 20. And I’m certain I’ve never hit all of the first 6. I felt the algorithm validated decisions I’ve made over a period of several years, and this fund was a fit for my own approach to investing. Sector weighting also aligned with my own portfolio strategies. (click to enlarge) I have a modest allocation to a dual-momentum sector-switching strategy. For the past year and a half or so it’s been in information tech, healthcare, consumer discretionary most of the time it hasn’t been in the out-of-market position. The QUAL index has loaded the portfolio with 70% allocation to those sectors. Again, I felt I was moving along the same path. So, with the validation that my investment strategies and QUAL’s index algorithm were generating similar choices, it seemed clear that I had to look more closely. QUAL’s Strategy and Implementation Quality can be a nebulous concept. The most important question was: How does the fund define quality? According to the fund’s factsheet they use “three fundamental variables: high return on equity, stable year-over-year earnings growth and low financial leverage.” Not unreasonable indicators of Asness’s “safe, profitable, growing, and well managed” definition of quality. The MSCI index description expands this with the quantitative details: A quality score… is calculated by combining Z scores of three winsorized fundamental variables-Return on Equity, Debt to Equity and Earnings Variability. MSCI then averages the Z scores of each of the three fundamental variables to calculate a composite quality Z score… then ranks all constituents of the parent index based on their quality scores. Weighting is determined by the product of market cap weight in the index and quality score. Weights are capped at 5%. As an aside to stock-pickers, think about how high MSFT and JNJ must score on the quality scale to overcome AAPL’s market cap advantage in rising above it in the weighting here. It’s an approach that should lead to emphases on both fundamental value and momentum. I liked what I saw, and feel most would agree that these indicators do indeed reflect a concept of a quality company. They are clearly necessary components of quality, although perhaps not sufficient. I’m sure all of us could add metrics we’d like to see included. But I was satisfied with it at this level. QUAL’s History The fund has 27 months of history (July 16, 2013) and net assets of $1.2B. The total portfolio is set at 125 holdings. SEC 30-day yield as of September 30 is 1.94%. Its beta is 0.92. And its fee is only 0.15%. Returns since the fund’s inception are about a third better than SPY and twice what BRK.B has turned in. (click to enlarge) For longer term evaluation we have to go to the index. It’s always problematic to base decisions on a fund using the historical performance of its index, but it’s what we have. Here we have MSCI’s 15 year chart of the index vs. its USA index of domestic stocks. (click to enlarge) Morningstar’s Samuel Lee looked at the fund and its index about a month after it was introduced ( here ). He called it a “Buffett in a Box,” and ran up this analysis where he divides the MSCI Quality Index by the MSCI USA Index. On this chart positive numbers represent outperformance of the quality index relative to the domestic market index. For the 30 years prior to QUAL’s inception the index outperformed by 60%. What you really want to see in this chart, however, is the changes in slope because the positive slopes represent periods of QUAL’s outperfomance. During bull markets, quality lags, but during downturns it shows its breeding. (click to enlarge) Lee compared QUAL to the Vanguard Dividend Appreciation ETF (NYSEARCA: VIG ) noting the he’ll be watching it in comparison to VIG with an eye toward moving his VIG position to QUAL if the fund evolved as he anticipated it should. Here’s what he would have seen when he followed through: (click to enlarge) Trading for Quality So, near the close on Friday I sold my entire position in BRK.B and put the proceeds into QUAL. I started my project to replace individual stocks with funds by focusing on BRK.B for two reasons. First, it has been turning in disappointing returns recently, and second I have a large allocation to the stock, larger than I feel appropriate. There are two other stocks I’m holding at much lower allocations that I have been looking to trade out of as well: JNJ and T. I like having both of them for the same reasons I like BRK.B: stability and quality. But, like BRK.B there underperformance comes with opportunity costs. How do those opportunity costs stack up against what QUAL has been returning? (click to enlarge) What this is telling me is that I can jack up my returns with little, if any, sacrifice in portfolio quality by moving these allocations to QUAL as well. The biggest problem I have with QUAL is one of the things that attracted me to it in the first place. That is the extent to which it duplicates what I’m already holding. I’m not prepared to trade out of GILD, COST or CELG at this time. I think each of those has excellent prospects to outperform the market and their sectors. I also hold a large (my largest, in fact) position in AAPL that I’d like to cut back. I’ll probably do so after earnings this week if, as I expect, we get another positive report. But my other duplications I’m more ambivalent about. I like MSFT and it is certainly not underperforming (75% total return vs. QUAL’s 33.5% on the scale of the above charts) but if I had a quality substitute, I would not miss it. The other I replicate is CVX where I’m underwater but am willing to wait for the oil cycle to turn before I do anything there. Of course, most funds I own replicate some part of my portfolio, especially with AAPL and GILD among the top holdings of nearly every fund I find interesting. Bottom line on this exercise for me: I like QUAL, perhaps as much as any ETF I’ve looked at recently. For my purposes, it can serve the same role in my portfolio as individual stocks of quality that have been, and likely will continue to be, underperforming the market.