The Quality Anomaly

Executive Summary

As GMO launches its first ETF, it seemed like a good time to share my thoughts on the market inefficiency that the strategy seeks to exploit ­– the quality anomaly. The basic goals of any active investor are to achieve higher returns and/or lower risk than a passive portfolio. These goals are, or at least should be, in conflict with each other. If financial markets were efficient, it would be impossible to sustainably achieve higher returns without taking on additional risk. And any portfolio that embodied lower risk would pay for it with lower long-term returns. At the highest level, markets basically work this way. Government bonds and cash are lower risk than high yield bonds and equities and have delivered lower returns across almost all markets and most time periods. But within risk assets, things get weird. Within both stocks and high yield bonds, you have historically been able achieve both higher returns and lower risk by owning the highest quality securities in those universes. This quality anomaly has been around for a long time and exists within multiple subsets of the equity universe. And for what it is worth, their opposite numbers have also been mispriced – low-quality stocks and CCC (and below) bonds have underperformed their broad universes despite their obviously greater downside in bad economic times. In an investing world where most trade-offs are difficult, this one is pretty easy. If you were going to have one permanent bias in your equity and high yield bond portfolios, it should be in favor of high quality.

The mispricing of quality

You may recall our spring edition of the Quarterly Letter, in which Tom Hancock and Lucas White wrote at some length about the quality anomaly in the stock market. 1 My goal in this piece is to expand on their work and show that the quality anomaly exists within multiple areas of the stock market and in the high yield market as well. But to start, it is worth a brief recap of some of my colleagues’ data. Exhibit 1, taken from their piece, shows the pattern of return and volatility for the highest and lowest quality quartiles of the MSCI ACWI stock index.


The fact that high-quality stocks have had lower volatility than low-quality ones should not come as a surprise to anyone. But their relative performance is another matter. In an efficient market, those risky low-quality stocks should offer a higher return to compensate for their higher risk, and owners of high-quality stocks should pay for their peace of mind in the form of a lower long-term return. The fact that the highest quality quartile of the market has outperformed the lowest quality quartile by 4% per year is utterly counterintuitive, astonishing, and demands to be incorporated when building sensible equity portfolios.