What could be more sensible than buying quality stocks, especially in times of uncertainty? After the tough market of 2022, many argued that a focus on quality stocks would be a good investment approach for 2023, and they were correct. The largest quality ETF by AUM is QUAL. QUAL was up 31% in 2023 vs the S&P500's 26% total return. Now, many advise buying quality stocks for 2024. The market has been rallying on the back of a sliver of tech stocks. So, owning Quality would seem reasonable conservative advice.

But why did QUAL outperform the S&P500 in 2023? Was it because of its weight in tech, which was considerably higher than the tech weight in the S&P500? SPY (ETF which tracks the S&P500) now has 34% weight in tech compared to 23% five years ago. However, QUAL now has 40% weight in tech, double the 20% weight it had five years ago. Has tech become synonymous with Quality?

Profitability is one of the main indicators of Quality. Return on invested capital (ROIC) is a well-regarded profitability measure, though not used for the quality definition of the stocks in QUAL. The chart shows the ROIC for XLK, the ETF tracking the S&P500 tech sector. ROIC for XLK peaked in the summer of 2022. At that peak, the ROIC of the large-cap tech XLK had doubled since the summer of 2016. So, yes, tech has increasingly been Quality by the profitability measure. When tech wins, passive quality investing has a significant tailwind.

If a risk to the market is the outsized influence of tech, then a passive approach to buying Quality doesn't materially reduce this risk. Buying Quality would make sense now, but it is likely better with lower, rather than higher, tech weight than the broad market. Active quality investing could be safer than passive quality investing. Let me know if you need help with this.

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