This Hidden Gem Vanguard ETF Is Chock-Full of Magnificent Stocks. Here's Why It's a Buy Now.

Many Vanguard exchange-traded funds (ETFs) are market-cap weighted -- so the most valuable companies in a theme or sector have the highest weighting.

For example, a growth or tech-focused ETF would probably have Microsoft, Apple, and Nvidia as the largest holdings. ExxonMobil would top the list of energy funds. Berkshire Hathaway would be a core holding in a value fund, etc.

The Vanguard U.S. Quality Factor ETF (NYSEMKT:VFQY) is unlike other ETFs. Its largest holdings have nothing to do with market cap. Instead, the fund uses a rules-based approach to classify companies based on quality.

Here's a look at the fund's holdings and why it stands out as a solid buy now.

Image source: Getty Images.

Defining "quality"

The Vanguard U.S. Quality Factor ETF has 364 holdings and a yield of 1.3% -- so about the same as the S&P 500.

The top five holdings are Apple, Gilead Sciences, 3M, Adobe, and Walmart. These companies have very little in common in terms of their business models and operations, but they have a lot in common based on the quality factor Vanguard assigns them.

You can think of the quality factor as a scorecard or rating for a company. If it is a financial company, Vanguard's quantitative model looks at return on equity and share issuance. For non-financial companies, it is based on return on equity, gross profitability, change in net operating assets, and leverage.

In other words, it doesn't really matter what industry a company is in so long as it is investing capital well and managing debt.

It's no surprise that Apple tops the list as the largest holding. Apple is highly profitable, has a staggering 150% return on equity, and has more cash, cash equivalents, and marketable securities on its balance sheet than long-term debt.

Looking under the hood

The ETF is one of those funds where it is especially useful to browse the list of holdings to get a better feel for what high quality looks like. But in the meantime, we can learn a lot from the fund's sector weights.

Data source: Vanguard.

As you can see in the table, the fund focuses heavily on a few sectors -- emphasizing business performance rather than capital return programs. For example, the consumer staples sector has plenty of recession-resistant, safe businesses, but it only has a 5.5% weighting in the ETF. One of the largest companies in the sector, Procter & Gamble (NYSE:PG), is what I would consider to be among the safest companies. It has also raised its dividend for 68 consecutive years and buys back a considerable amount of its own stock.

But maybe it doesn't have the highest quality factor because of a low return on equity or keeping a good chunk of debt on the balance sheet. Procter & Gamble is all the way down as the 119th holding in the ETF with a mere 0.25% weighting. It is arguably deserving of being much higher on the list.

A mix of growth and value

Another characteristic worth considering is that it doesn't matter how expensive a stock is relative to its earnings so long as it has a high quality factor. Chip giants Qualcomm, Lam Research (NASDAQ:LRCX), and Nvidia are, respectively, the seventh, 15th, and 30th largest holdings in the fund. All of these stocks have run up in price and are more expensive on a valuation basis. But their inclusion in the ETF showcases their excellent quality metrics.

Cyclical companies can face big swings in profitability. And right now, chip companies are in a meteoric expansion period. However, since no single stock has more than a 2.3% weighting in the fund, and holdings outside the top 30 have less than a 1% weighting, there isn't a high risk of the fund getting over-concentrated in a single industry.

The majority of the fund is in inexpensive value stocks and low- to medium-growth companies that are very good at what they do. For example, TJX Companies is a top 10 holding, and Ross Stores clocks in at 22nd. Familiar blue chip companies of the Dow Jones Industrial Average, like Visa, American Express, Johnson & Johnson, and Merck are all top-20 components.

The key takeaway is that the fund has a nice mix of growth and value stocks, from well-known industry leaders to companies you may have never heard of.

A fund worth following

The Vanguard U.S. Quality Factor ETF isn't perfect, and so far this year it has trailed the S&P 500. As with any rules-based fund, it's important to understand why some companies can be highly rated while others are lower. But I would argue that no ETF is perfect, not even Vanguard's hottest ETF, the Vanguard S&P 500 Growth ETF.

Despite being arguably the most important stock market index in the world, the S&P 500 has plenty of poor-performing companies that are losing market share and are only in there because they carved out a competitive advantage decades ago. And yet, the S&P 500 has created lasting, generational wealth for patient investors.

The Vanguard U.S. Quality Factor ETF is worth buying if you're interested in a different kind of ETF with unique characteristics. Even if you're not interested in buying the fund, it can still be a valuable resource for looking for quality companies based on certain criteria.

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American Express is an advertising partner of The Ascent, a Motley Fool company. Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Adobe, Apple, Berkshire Hathaway, Gilead Sciences, Lam Research, Merck, Microsoft, Nvidia, Qualcomm, and Walmart. The Motley Fool recommends 3M, Johnson & Johnson, and Tjx Companies and recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.