What is Quality?

Northern Trust

Michael Hunstad

Research

20 Pages

Northern Trust examines how “quality” investing should actually be defined and why high quality stocks have historically outperformed despite lower risk. The paper challenges CAPM assumptions, arguing investor preference for speculative, lottery-like payoffs may help explain why weaker companies can become overpriced relative to businesses.

Key Takeaways

Quality Return Spread: High quality Russell 3000 stocks returned 19.0% annually versus 5.1% for low quality names from 1979 to 2012, with nearly 5x higher Sharpe ratios.
Multifactor Edge Matters: Northern Trust’s proprietary quality score produced 9.4% average annual returns with 5.2% volatility, outperforming competing quality definitions between 1985 and 2012.
Speculation Distorts Pricing: The paper cites annual gaming wagers approaching $2 trillion to $3 trillion, suggesting risk-seeking behavior can inflate lower quality stocks despite weaker expected returns.
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