O'Shares FTSE U.S. Quality Dividend ETF - An Exceptionally Well-Crafted Fund (BATS:OUSA) (2024)

O’Shares FTSE U.S. Quality Dividend ETF is a well-crafted fund that deserves a place in your portfolio despite its 0.48% expense ratio. One reason is that my private research came to the exact same conclusion as they did before I ever looked at their fund. I will highlight the reasons in the article below. The cross-section of the three themes creates a powerful bulwark that is essential during economic uncertainty.

Kevin The ETF Powerlifter

The O’Shares FTSE U.S. Quality Dividend ETF (BATS:OUSA) selects stocks based on three criteria:

• Quality
• Volatility
• Yield

If you read the fact-sheet you will see that they highlight the investment principles of providing income, diversification and capital appreciation. The goal is to provide more income with less risk and long-term price performance. How do they go about achieving their goals?

Volatility

Risk is a term that is used by virtually every investor yet it is difficult to define. Risk of what?

• Risk of a total loss or bankruptcy?
• Risk of dividends being cut?
• Risk that you cannot liquidate your holdings in a timely manner and at a good price?

All of these are valid forms of risk. What type of risk can a low volatility portfolio help mitigate?

Suppose you had 2 investments which had the same long-term rate of return. If all fundamental and valuation factors are equal, would you say they have the same risk?

I feel that the iShares Edge MSCI Min Vol USA ETF (USMV) would be the better of the two portfolios (blue line). The other portfolio (red line) is more unpredictable. Predictability is an important quality when you require a certain amount on a fixed date and especially if you unexpectedly need to tap into these funds. Even if both portfolios drop by the same amount in a bear market and have the same long-term compound annual growth rate, the portfolio which has a higher degree of price stability and predictability will have a less unpredictability risk.

Of course, all other factors are never equal so it is necessary to go further than analyzing price performance and volatility.

High Quality

Quality is another term that is thrown around a lot but often carries a murky definition. How can quality be defined? The AQR Capital Management research paper, Quality Minus Junk, defines quality as a group of characteristics that investors should be willing to pay a premium for. These properties include the following:

• Safety
• Profitability
• Growth
• Sound management

Suppose you had two stocks which had the same market-cap and the same price-to-earnings ratio. They are valued the same and have the same earnings. An examination of ‘quality factors’ would reveal how well each company is utilizing its assets to generate profit. This quality check-up would also include the following:

1. An examination of profitability growth – is the company becoming more wasteful or are they becoming more efficient over time?
2. And what about safety…does the company have high credit risk?
3. Are they highly leveraged?
4. Does profitability vary wildly over time?

The interesting aspect about quality is that investors often under-value it. High quality stocks may actually underperform in extended bull markets. During market crashes, these stocks often hold up better than their peers as investors flee to quality and safety. Therefore, it is difficult to analyze the returns of high quality stocks in a bull market to determine its true worth. High quality is a latent defense against market and economic downturns.

The chart directly above highlights the equal-weight return of 50 high quality dividend-paying stocks in the Russell 1000 index versus the iShares Russell 1000 ETF (IWV). The equal-weight return of the Russell 1000 (not the cap-weighted return of IWV) for this period is 9.4% with a maximum draw-down of 59%.

Thus, high quality stocks help mitigate some of crash risk.

Dividend Yield

Many investors are showing a preference toward dividends for more reasons than just providing income. Consider the following 3 research papers:

• What do Dividends Tell Us About Earnings Quality? (Skinner, Soltes, 2009)
• Do Dividend Payments Mitigate Stock Price Crash Risk Through Curbing Bad News Hoarding and Curtailing Overinvestment? (Kim, Luo, Xie, 2018)
• Dividend Policy at Firms Accused of Accounting Fraud (Caskey, Hanlon 2013)

Firms which pay dividends also exhibit higher earnings quality. The earnings are more trustworthy and have a higher probability of being sustainable. Stocks with dividends have lower risk to a price crash. This is linked to a lack of inefficient empire-building which harms shareholder value, a lack of bad news hoarding and a higher degree of financial transparency. Dividend paying stocks are also less frequently found among firms charged with fraud.

O’Shares FTSE U.S. Quality Dividend ETF And Me

Before I ever analyzed the O’Shares FTSE U.S Quality Dividend ETF, I came to the same conclusion that volatility, quality and yield were 3 extremely important themes that work together synergistically. A combination of these themes provides investors with income while lowering their risk to crashes, fraud and waste of shareholder equity. I applaud this fund for incorporating these 3 themes.

In fact, my own construction of a ranking system to isolate the best dividend growth stocks uses these exact 3 themes.

Other ETF Considerations

Weighting Methodology. My least favorite weighting methodology is based on market capitalization. This write-up by Jason Hsu published in 2006 titled, Cap-Weighted Portfolios are Sub-Optimal Portfolios, highlights the pitfalls of such a scheme. The potential for under-performance can be quickly summed up in the following example.

• The stock market is noisy and prices may temporarily deviate from their true value but revert back over time.
• You have two stocks which have the same fundamental value although you are not aware of this at the time.
• One stock has a market cap of $2 billion and the other is $1 billion. The unknown fundamental value for both companies $1.5 billion. One stock will appreciate by 50% while the other will drop by 25%.
• An equal-weight investor will earn 12.5%.
• A cap-weighted investor will earn 0% because he double-weighted on the more expensive stock.

Large market-cap stocks have a high correlation to large firms and companies. But they are not the exactly the same. The largest firms are more accurately represented with a fundamental weighting methodology which may look at total revenues, profits, dividends, book value or even employees. It isolates the firms which have the largest economic foot-print and not merely the companies which have the most expensive stock.

So it is with a little sadness that I see a modified cap-weighting strategy with OUSA. The reason they use cap-weighting likely relates to lowering rebalancing fees and ensuring enough liquidity. Yet, if an ETF is to use cap-weighting at all, I am glad that they use this modified strategy as outlined below.

Tilt-Tilt Methodology

How can we understand the process without getting too deep into the mechanics of the weighting methodology?

Assume we grade 3 stocks from 0 to 100 based on quality, volatility and yield.

Which of these stocks represents the best balance of quality, volatility and yield factors? Notice that when we sum the scores across the three themes it results in the same score of 210. Yet these 3 stocks are far from being equal. Stock A has high quality and yield but terrible volatility. Stock B is lacking in yield. Stock C has moderately strong measures across all three themes. What is hidden when summing the scores becomes apparent when you multiply them together. Stock C is our preferred choice for a balance of these factors.

If we weight positions using the sum method, all stocks would be held equal-weight. If we weight positions using the multiplication method, stock C will have over triple the weight of stock A.

The tilt-tilt method is then multiplied by the market-cap weight and normalized.

• Assume that stock A has a market cap of $34.3 billion and stock C has a cap of $10 billion. In a pure cap-weighted scheme stock A would have over 3x the weighting due to its size.
• In our modified cap-weighting scheme using the tilt-tilt method, the 2 positions would be held equal-weight.

While I dislike cap-weighting, I appreciate that the fund recognizes the pitfalls and offsets the need for higher liquidity with higher scoring stocks.

Expense Ratio

The expense ratio is 0.48%. If this was a poorly constructed fund, I would slam those fees as being exorbitant and wasteful. Yet, as I analyze the thought and care that went into this fund along with a balanced approach towards weighting positions, I do not believe that this expense ratio is overly expensive. I would call it a competitive price for a high-quality product.

I would much rather pay 0.48% for a well thought-out fund with various risk-reducing measures in place as opposed to a hastily put together fund even if no expense ratio existed.

Ways It Could Improve

If I were to make a few suggestions for future funds – what would they be?

1. Incorporate the concept of value. This could be a cross-section of high-yield and low payout ratio or preferably a high free cash flow yield such as is employed in the AAM S&P 500 High Dividend Value ETF (SPDV). High FCF yield also supports dividend sustainability.
2. Tilt ETFs, particularly the smallcap version (OUSM), towards liquidity rather than market-cap. While this may affect turnover somewhat, it will improve capacity of the fund.
3. Focus on dividend growth stocks which have a history of annually increasing dividends.
4. Develop a short ETF based on highly volatile and low-quality stocks which either have no dividends or very high dividend yields. Investors could mix this ETF with OUSA to create a hedged portfolio for further protection against a down market.
5. All ETF holders of 1,000 shares or more get a monthly order of complimentary Wicked Good Cupcakes.

Summary

OUSA is an exceptionally well-crafted fund. There are strong risk-reducing properties that are not apparent when analyzing the price performance. In fact, quality stocks are often the most under-valued when they are needed the most for portfolio safety…before a crash.

There is likely no better time than right now to add OUSA to your portfolio blend of ETFs. I am generally quite skeptical of ETFs and the far majority of them are simple factor tilts which make no efforts to mitigate risk. But OUSA does what it sets out to do: provide income with less risk with a view to long-term performance.