Reading the swell: Quality and the waves in Australian equities

Markets move in waves, too. In international markets, a quality approach has helped investors hold their form when markets get choppy. The challenge for Australian investors is that quality investing has been elusive. A tight market, fuelled by high stock and sector concentration, mean quality is indistinguishable from value, growth and momentum.

This was highlighted earlier in the year by Morningstar in an article Where to find opportunity in an expensive market.

“Defining quality stocks in Australia is a little fuzzier,” the author explained, highlighting the markedly disparate returns between three quality indices. “Why the big gaps in performance? Well, each of them filters different characteristics for quality stocks, and I’m not sure any of them get it close to right.”

We agree. A VanEck research paper, The limits of quality in Australia, analysed the quality indices Morningstar wrote about.

The limits of quality in Australia highlighted the historical success of the quality factor in international equity markets, where it has been an effective relative defensive strategy over the long term. Quality investments, as represented by the MSCI World Quality Index relative to MSCI World Index, have delivered lower beta, shallower drawdowns and risk-adjusted outperformance during periods of market stress, and lower inflation and growth regimes.

The paper found that the quality indices that we analysed could not achieve these outcomes for three reasons:

• Stock concentration,
• Sector concentration, and
• A small starting universe.

Further, we found that one of the indices rebalances annually. An annual rebalance means the portfolio is slow to respond to deteriorating factor signals. This is more problematic given the more cyclical nature of the Australian equities market.

In the conclusion of that piece, we wrote, “This does not mean quality cannot be achieved in Australian equities, but rather that a pure single-factor quality approach is unlikely to be the most effective implementation in a concentrated, cyclical market such as Australia. The more effective path is an index that places quality characteristics at the centre of construction and uses complementary characteristics to manage the sector and concentration risks that undermine single factor approaches in this market. Identifying the most effective implementation approach is a priority within our ongoing research.”

We have been analysing and assessing the quality factor in Australian equities since we launched our MSCI International Quality Equities ETF (ASX: QUAL) in 2014. As leaders in smart beta, it was imperative for us that an Australian quality strategy provide investors with outcomes a quality investor would expect, as it has with QUAL. That is risk-adjusted long-term outperformance, lower beta (which is a measure of risk), losing less in drawdowns and relative outperformance to the broader market during periods of market stress and lower inflation and growth.

The fruition of 12 years’ worth of research and analysis was realised last week with the release of The Narrow Market, Untangled: Building a stronger core in a concentrated market.

The paper assesses the implications of combining factors in Australia. The paper finds that the MSCI Australia IMI Quality Plus Index (AQTY Index), a custom index developed by MSCI in collaboration with VanEck, may potentially provide Australian investors with a way to achieve quality investment outcomes in their home market.

AQTY Index is built around the quality factor as its anchor, drawing on MSCI's core quality fundamentals, profitability, earnings quality, investment quality, earnings variability and leverage. Two factors are added to complement the signal: enhanced value, which enforces valuation discipline by screening out stocks where quality is priced in, while low volatility addresses a specific gap in the Australian market, where quality alone has historically failed to deliver the defensive beta profile seen in deeper global markets.

Quality identifies the earnings and balance sheet, value prevents the portfolio from becoming expensive, and low volatility dampens downside sensitivity. Momentum is also considered, playing a supporting role, acting as a deterioration screen that filters out stocks whose fundamentals may be weakening before it shows up in reported financials.

The Narrow Market, Untangled: Building a stronger core in a concentrated market has analysed the performance, holdings and characteristics of MSCI’s modelled AQTY Index since 2002. In summary, we found that AQTY Index expresses quality characteristics through its combined factor framework while its modelled history delivered risk-adjusted outperformance over the long term, and it achieved this within the structural limitations of the Australian equity market. Noting that past performance of the AQTY Index is not indicative of the future performance of the index or of AQTY.

Australian investors will soon be able to chase the Australian equity quality outcome dream.

We launched the VanEck MSCI Australian Quality Plus ETF (ASX: AQTY) on 1 June 2026, which tracks the AQTY Index - a new way to ride the Australian equity wave.