E ver been passed over for promotion by some smooth-talking stuffed shirt? Then take heart from the profitability factor. Also known as the quality factor. this is a real-world example of the triumph of the best over the rest.

The profitability/quality factor reveals that companies that make the best use of their capital outperform their less efficient brethren over the long-term.

In fact, the most profitable companies can bring home a return premium that has hitherto beaten the market by up to 4% a year .

The trick is to invest in the companies that are rippling with the signs of financial prowess most likely to predict profitability in the future.

Like a Moneyball chief scout or an international Top Trumps player, you need to know which stats matter most

or you could just pick an Exchange Traded Fund (ETF) with Quality in its name.

Quality over quantity

There are only three quality factor ETFs currently available to UK investors. Choosing one shouldn’t take long, right?

The snag is that financial engineers have more definitions of quality than the Eskimos have words for snow.

True, every kind of return premium can be formulated in different ways

But quality comes in so many flavours that you just know some must be watered down.

How do you choose the right version of quality? Is there a right version? Which has performed best historically? Does it even matter?

A trip down quality street

First of all, it’s important to understand that quality can be defined by a single measure, or by a cocktail of stats as drawn from a company’s annual report.

Here’s a snapshot of the yardsticks used by different industry practitioners:

• Return On Equity (ROE) – One of the most commonly used quality metrics.

• Gross profits / assets – This is gross profitability as defined by Professor Novy-Marx and widely considered to be the champagne of quality factors.

• ROE, debt to equity and earnings variability – Used by the MSCI Quality Indices.

• Stability of earnings and dividends over the last 10 years – The S&P formula.

• Gross profits / assets and gross profit margins plus free cash flow / assets – The preference of US fund house AQR.

• Net income, operating cash flow, return on assets, stability of earnings, leverage, liquidity equity issuance, gross margins and asset turnover – The Piotroski F-Score financial health test.

Novy-Marx’s work caused a stir because his gross profitability metric trounced the market by 4% a year between 1963 and 2011. As a single quality metric it’s tough to beat and I’d want it or a close proxy in any quality fund I bought into.

However even Novy-Marx thinks that the best quality metric will be a blend of measures. For example, cash flow / assets is unpolluted by some of the accounting inconsistencies that can interfere with the gross profitability signal.

The question then is do the available ETFs offer us the finest quality cuts, or are they slipping in some horse meat?

(Or – worse – horse output!)

Quality ETFs

The three ETFs I mentioned earlier all track developed world equities, using a blended metric to tilt their holdings towards the quality end of the spectrum.

The higher a stock scores on the fund’s quality scale, the greater its presence, subject to any applicable cap.

Note: These ETFs are so new that it’s not even worth considering their track record – they just haven’t been around long enough for their track record to be relevant.