ETF investors who are thinking about filling out their core portfolio can consider the benefits of moat investing strategies that enhance portfolios through a smarter investment style.
On the recent webcast (available On Demand for CE Credit), Moat Investing through a Factor Lens, Edward Lopez, Head of ETF Product Management at VanEck, highlighted the fact that Morningstar’s moat investing approach has generated impressive long-term performance, with the Morningstar Wide Moat Focus Index significantly outperforming the S&P 500 Index and the average active and passive mutual funds and ETFs in the Morningstar Large Blend category since 2007. The Morningstar moat methodology has target companies trading at attractive prices relative to their fair value, helping investors enhance returns over time.
However, the methodology is not without its drawbacks. Lopez warned that the wide economic moat theme is generally short momentum by nature since it targets undervalued companies, which has hurt the strategy in recent years, but the investment style may prove beneficial if momentum breaks down.
To help better define the Morningstar investment methodology, Andrew Lane, Chairman of Economic Moat Committee for Morning Star, explained that an economic moat is a “durable competitive advantage that allows a company to generate positive economic profits for the benefit of its owners over an extended period of time.”
When it comes to a company’s moat or competitive advantage, Morningstar would highlight five specific factors, including High Switching Costs, Cost Advantage, Intangible Assets, Network Effect and Efficient Scale. Companies rated with a wide economic moat are seen to have a long-term competitive position. Lane argued that it is “more than just finding rapid-growth business or buying cheap stocks” but “also evaluating whether a business will stand the test of time.”
Specifically, Intangible Assets refers to things such as brands, patents, and regulatory licenses that block competition and/or allow companies to charge more.
Switching Costs determines whether in time or money, the expenses that a customer would incur to change from one producer/provider to another.
Network Effect is present when the value of a service grows as more people use a network.
Cost Advantage allows firms to sell at the same price as competition and gather excess profit and/or have the option to undercut competition.
Lastly, Efficient Scale is when a company serves a market limited in size, new competitors may not have an incentive to enter.
The result is a company with wide economic moats that enjoy structural competitive advantages to generate high returns on capital for an extended period and sustainable returns on capital, which are much more important than high returns on capital. Essentially, Lane argued that economic moats help reflect a company’s intrinsic value.
The VanEck Vectors Morningstar Wide Moat ETF (NYSEArca: MOAT) implements Morningstar’s economic moat rating to identify strong companies with wide economic moats. The VanEck Vectors Morningstar International Moat ETF (NYSEArca: MOTI) takes a similar moat rating methodology to select overseas component holdings. The recently launched VanEck Vectors Morningstar Global Wide Moat ETF (GOAT) implements its economic moat indexing methodology with an all-encompassing global exposure.
“Morningstar’s moat investing philosophy combines the rigorous, forward-looking economic moat and valuation research into the Morningstar Wide Moat Focus Index that targets quality, wide-moat companies trading at attractive prices. It reconstitutes on a quarterly basis in order to capture this investment opportunities consistently throughout the year,” Lopez added.
Financial advisors who are interested in learning more about the smart beta strategy can watch the webcast here on demand.