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10An ERI Scientific Beta Publication — The Dimensions of Quality Investing: High Profitability and Low Investment Smart Factor Indices — July 2015Copyright © 2015 ERI Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.1. High Profitability and Low Investment as Factors1.1. Evidence-Based “Quality” DefinitionsAsset managers and index providers are increasingly touting the benefits of quality investing. Suchstrategies tilt portfolios to “high quality” stocks, as characterised for example by high profitability,stable earnings, or low leverage, to name but a few of the variables used in practice. However,asset managers and index providers do not use a common definition of “quality,” and a wide varietyof approaches exist. Two different factors have been introduced in the empirical asset pricingliterature to proxy two different dimensions of so-called “Quality”:Profitabilitye.g. Gross ProfitabilityInvestmente.g. Growth of Total Assets(1)High Profitability and Low Investment have recently been identified as rewarded risk factors inthe long run. There has been strong evidence and a straightforward economic explanation forthe existence of a premium for these two factors and extensive literature has come up with manymulti-factor asset pricing models that include these factors in their models. The academic literaturedescribes profitability and investment as two different risk factors, each with its own risk premium.However, commercial index providers often bundle these factors and brand them as “Quality”indices.1.1.1. Picking Quality Stocks vs Quality Factor InvestingThe premise of quality investing is that high quality stocks are not sufficiently recognised by themarket to increase their price to a level that fully reflects their superior quality - therefore suchstocks offer a good investment opportunity. These approaches try to add alpha in a systematic wayakin to what a stock picker does. The concept has been traced back to fundamental stock pickerssuch as Benjamin Graham, Jeremy Grantham and Joel Greenblatt. The stock picking philosophyappears to be based on a naive belief that systematic rebalancing of an index based on accountingdata allows alpha to be generated. In practice, systematic screening offered today by numerousindex providers aims to procure alpha in competition with traditional asset managers, withoutnecessarily having all of the same characteristics, and notably the capacity to take account offorecasts on the evolution of stock characteristics or new factors that can change the perception ofthose characteristics.For academics and proponents of a beta, rather than an alpha, approach, which in our view is theonly approach that is compatible with index investment, the term “quality” refers to a completelydifferent dimension: the factor approach.(2)