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46An 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.AppendixOur Answers to Frequent Discussions on Quality InvestingIn this appendix, we cover two issues with investment and profitability smart factor indices, which areworth exploring in more detail. First, we consider whether adjustments are necessary for investmentand profitability factor scores for stocks in different industries. Second, we discuss the link betweenthe well-known value factor on the one hand, and the profitability and investment factors on theother hand.A.1. Scoring Stocks in Different IndustriesIn this section of the appendix, we briefly explain how ERI Scientific Beta is treating financial firmsagainst non-financial firms in the construction of investment and profitability smart factor indices. Webriefly recall the lack of guidance in the academic literature on the treatment of financials. We then listthe options considered in practice to tackle the industrial structural biases in factor selection-basedproducts and describe how we opt for using consistent investment and profitability proxies acrossindustry (or industry family) while using industry-adapted financial data items in the calculation ofthose proxies.Investment and profitability factors in financials: Quick reminderThere is no visible academic recommendation as how to treat financial companies in the calculationof quality factors in general, and in the investment and profitability factors in particular. In fact, mostof the academic literature on those factors excludes financial firms from their analysis.ProfitabilityWe remind readers that ERI Scientific Beta proxies the profitability selection criteria by the GrossProfitability Ratio (GPR) of a firm, as given in Novy-Marx (2013, 2014):We note that Novy-Marx (2013) excludes financial firms from the analysis, but mentions that includingfinancial firms, wherein the item of Cost of Goods Sold (COGS) is replaced by operating expensesfor financial firms, does not change the results significantly. Fama and French (2006), wherein theproxy for profitability is the ratio of expected earnings to book equity (projected ROE), also excludefinancial firms from analysis. Fama and French (2014), wherein the proxy for profitability is the ratioof operating profit to book equity, do not specify whether financial firms are included or excludedfrom the analysis.InvestmentThe investment factor is proxied by Total Asset Growth of a firm as given in Cooper et al. (2008)
An 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.47AppendixSimilarly, and notably in order to smooth the important turnover that stems from using year-on-yearchange in assets, ERI Scientific Beta defines Total Asset Growth as the 2-year change in total assets, as:For this factor, we note that the literature also excludes financial firms from the analysis as authorsargue those firms exhibit different sets of accounting measures compared to the non-financial firms.In general, the structural differences observed in financial firms’ accounting and revenue lines cantranslate into structural differences in the investment and profitability ratios, and that is mainly whyfinancial stocks are excluded from the quality literature.This is particularly intuitive in the case of profitability, since financial firms have larger asset basesthan other companies, it will scale any measure of profits divided by assets results in financial firmsexhibiting low profitability ratios compared to non-financial firms.Also, some argue that the asset base of financials should not include debt and should be limited tothe book equity in calculating the investment proxy change in total assets.In any case, index providers typically aim to provide factor indices based on standard “parent indices”,which include financial firms. Therefore, the question of how financial firms should be treated arisesin this context. We describe below the alternative options available, and we instantiate in particularERI Scientific Beta’s approach in doing so.Different approaches to the treatment of industry differencesThere are mainly three ways to account for structural accounting differences across industries incriteria-based stock selection, of which Scientific Beta has chosen the last mentioned approach below.Calculating investment and profitability proxies per industry/industry familyThe first way to cancel industry effects is to implement criterion-based stock selection per comparableindustry/industry family. In our case, one would rank financials and non-financials separately on thesame profitability and investment proxies, and then aggregate the resulting selections in proportionof e.g. market capitalisation in the reference cap-weighted index. Such an option is not particularlydesirable in the smart beta context, since it will distort the effects of the smart beta weighting acrossthe whole index.Using different investment and profitability proxies per industry/industry familyThe second approach is to use different proxies across different sets of fundamentally comparableindustries.
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