MOAT Delivers Quality with a Forward-Looking Edge

This year, investors have poured over $14B into U.S. equity ETFs that target exposure to the quality factor, according to Morningstar. Much of that investment coincided with the weeks following the failure of Silicon Valley Bank, but notable inflows continued in April and May. As uncertainty abounds, investors appear to be seeking well-positioned companies that can withstand market turmoil.

This is not that surprising. The S&P 500 Index is notably difficult for U.S. large-cap active managers to outperform in both strong and weak markets. Therefore, logically, investors may look to index-based strategies targeting specific factors that may provide a desired return profile in the current environment. A similar thought process led low volatility strategies to become very popular in the years following the 2008 Global Financial Crisis, and more recently drew investors to value-oriented strategies as those companies finally proved attractive relative to growth companies for the first time in many years.

But are investors getting what they want from quality equity ETFs? More to the point, what is it that investors are actually looking for from these strategies?

What Is Quality?

Measuring the quality of a company from an equity investor perspective can be nuanced. Most academics and practitioners agree that quality is the least agreed-upon factor. Generally, however, several characteristics are commonly associated with quality:

1. High and/or Stable Profitability: Profitable companies are typically considered to have well-run business models and control of their costs. Common measures of profitability are return on equity, cash flow returns on investment or free cash flow yield.
2. Profitability Growth: Better yet, companies that are increasing their profitability can signal improving demand, economies of scale or lack of suitable competition. Earnings per share growth is often the go-to metric for measuring profit growth.
3. Low Leverage: Companies with lower debt burdens may correlate with stronger balance sheets and lower macroeconomic risks. Debt to capital is a common measure of leverage.

What Is a Quality Outcome?

From an outcome perspective, these quality characteristics would be expected to facilitate upside participation when markets are appreciating, as well as to help mitigate losses when markets enter a rough patch. That hasn’t always been the case, as seen in recent periods of market turmoil. In 2022, when many investors were seeking quality company exposure, many were left with more downside and lower overall returns. Similarly, in late 2018 as geopolitical turmoil pushed markets negative, so-called quality companies underperformed.

Source: Morningstar. Max drawdown represents the largest decline within the stated time period. Past performance is no guarantee of future results.

Similarly, quality stocks have been inconsistent in rising markets. Their strong financial health and profitability profile hasn’t always benefited investors relative to the S&P 500 Index. The MSCI USA Sector Neutral Quality Index has an upside capture ratio of less than 100, indicating that it participated less in periods when S&P 500 returns were positive.

This means that many investors seeking quality companies via factor indexes may not experience the protection they desire and also may potentially miss out on market recoveries. Factor investing can be a powerful tool, but it is constructed through a backward-looking lens and factors can be extremely difficult to time.

Forward Looking Approach to Quality Investing

I would argue Morningstar’s moat investing philosophy represents a more practical approach to identifying high quality companies. Their economic moat framework considers quantitative inputs—such as returns on invested capital and costs of capital—to determine the staying power of a company’s competitive advantages, but it also relies heavily on forward-looking qualitative assessments by analysts. Morningstar’s equity research team can reflect, in real time, their view on which companies possess the most sustainable advantage—those with true staying power. Their moat framework looks out decades into the future to make that determination. Conversely, factor-based strategies will use historical inputs from a company’s balance sheet and income statement to assemble a portfolio. Morningstar has created the Morningstar Wide Moat Focus Index to capture those companies that are high quality today and expected to remain high quality many years into the future.

Equally important to the Morningstar Wide Moat Focus Index’s success is getting valuations right. Remember, factors are very difficult to time. A single factor ETF may perform very well in certain environments, but not others. The same can be said about wide moat companies. The Morningstar Wide Moat Focus Index uses Morningstar’s forward-looking valuation process to determine what moat-rated companies to own each quarter. The Index selects the most attractively priced relative to Morningstar analysts’ fair value estimate for the company. This focus on paying a fair price for exposure to high quality companies has allowed the Index to provide risk mitigation in difficult markets and exploit mispricing in order to participate in the upside.

Moat Investing: Quality Outcomes in Drawdowns and Recoveries

Source: Morningstar. Max drawdown represents the largest decline within the stated time period. Past performance is no guarantee of future results.

Looking at more than 15 years of data, the Morningstar Wide Moat Focus Index has offered the long-term high-quality outcomes expected by investors seeking out financially strong businesses. Its use of valuations to select among high quality companies with moats has resulted in impressive risk-adjusted returns, while offering both higher participation on the upside and buffering on the downside.

Source: Morningstar. Data calculated with quarterly returns. Past performance is no guarantee of future results.

Morningstar’s Moat Investing Outperforms Factors

Quality is certainly not the only single factor investment strategy out there. Many others have been identified in an academic setting and further developed into commercial applications by way of indexing. Again, timing these factors is very difficult. Morningstar’s systematic process of identifying high quality companies at attractive prices has allowed it to outperform the major style factors over many time periods, short-term and long.

Moat Investing Outpaces Factors Over Many Time Periods

Source: Morningstar. Data as of 6/20/2023. Minimum Volatility represents the MSCI USA Minimum Volatility Index; Momentum represents the MSCI USA Momentum SR Variant Index; Quality represents the MSCI USA Sector Neutral Quality Index; Size represents the MSCI USA Low Size Index; Value represents the MSCI USA Enhanced Value Index. Past performance is no guarantee of future results.

Moat Investing: A Better Approach to Quality

The turbulence of the last year has led to a discernible emphasis on quality as a beacon in uncertain markets. The effectiveness of these strategies, however, is up for debate. While traditional quality factor strategies offer some allure, they have often underperformed in the face of market stress and recovery due to their retrospective nature.

A potentially more viable alternative is Morningstar’s moat investing philosophy which, by incorporating both quantitative and qualitative forward-looking evaluations, redefines the approach to quality investing. The Morningstar Wide Moat Focus Index stands out in this realm, delivering impressive risk-adjusted returns by centering on attractively priced, high-quality companies. Consequently, investors seeking an effective blend of market protection and performance may find this strategy an optimal tool for their investing toolkit. (For more on how this approach has performed vs. the S&P 500 over the past decade, read: Decade of Dominance: The ETF that Quietly Beats the S&P 500.)

Investors can access Morningstar’s moat investing strategy through the VanEck Morningstar Wide Moat ETF (MOAT). MOAT seeks to replicate as closely as possible, before fees and expenses the price and yield performance of the Morningstar Wide Moat Focus Index.

Originally published by VanEck on June 29, 2023.

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Important Disclosures

Source for all data unless otherwise noted: Morningstar.

This is not an offer to buy or sell, or a recommendation to buy or sell any of the securities, financial instruments or digital assets mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, tax advice, or any call to action. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results, are for illustrative purposes only, are valid as of the date of this communication, and are subject to change without notice. Actual future performance of any assets or industries mentioned are unknown. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck or its other employees.

Fair value estimate: the Morningstar analyst’s estimate of what a stock is worth. Price/Fair Value: ratio of a stock’s trading price to its fair value estimate. Standard Deviation is a historical measure of the variability of returns relative to the average annual return. A higher number indicates higher overall volatility. Sharpe Ratio is a risk-adjusted measure that is calculated using standard deviation and excess return to determine reward per unit of risk. The higher the Sharpe ratio, the better the fund’s historical risk-adjusted performance. Sortino ratio takes an asset or portfolio’s return and subtracts the risk-free rate, and then divides that amount by the asset’s downside deviation. Upside Capture measures whether an index outperformed a calculation benchmark index in periods of market strength. A ratio over 100 indicates an index has generally outperformed the calculation benchmark index during periods of positive returns for the calculation benchmark index. Downside Capture measures whether an index outperformed a calculation benchmark index in periods of market weakness. A ratio of less than 100 indicates that an index has lost less than its calculation benchmark index in periods of negative returns for the calculation benchmark index.

MSCI USA Minimum Volatility Index aims to reflect the performance characteristics of a minimum variance strategy. MSCI USA Momentum SR Variant Index represents the momentum factor by considering a volatility-adjusted 12-month and 6-month excess return. MSCI USA Sector Neutral Quality Index aims to capture the performance of securities that exhibit stronger quality characteristics relative to their peers within each sector. MSCI USA Low Size Index represent the size factor within large and mid-cap US stocks. MSCI USA Enhanced Value Index represents companies exhibiting the value style characteristics. S&P 500 Index consists of 500 widely held common stocks covering industrial, utility, financial and transportation sector; as an Index, it is unmanaged and is not a security in which investments can be made.

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Effective June 20, 2016, Morningstar implemented several changes to the Morningstar Wide Moat Focus Index construction rules. Among other changes, the index increased its constituent count from 20 stocks to at least 40 stocks and modified its rebalance and reconstitution methodology. These changes may result in more diversified exposure, lower turnover, and longer holding periods for index constituents than under the rules in effect prior to this date. Past performance is no guarantee of future results.

An investor cannot invest directly in an index. Returns reflect past performance and do not guarantee future results. Results reflect the reinvestment of dividends and capital gains, if any. Certain indices may take into account withholding taxes. Index returns do not represent Fund returns. The Index does not charge management fees or brokerage expenses, nor does the Index lend securities, and no revenues from securities lending were added to the performance shown.

The Morningstar^® Wide Moat Focus Index^SM was created and is maintained by Morningstar, Inc. Morningstar, Inc. does not sponsor, endorse, issue, sell, or promote the VanEck Morningstar Wide Moat ETF and bears no liability with respect to that ETF or any security. Morningstar^® is a registered trademark of Morningstar, Inc. Morningstar^® Wide Moat Focus Index^SM is a service mark of Morningstar, Inc.

The Morningstar moat-driven indexes represent various regional exposures and consist of companies identified as having sustainable, competitive advantages and whose stocks are attractively priced, according to Morningstar.

The Morningstar^® Wide Moat Focus Index^SM Intended to track the overall performance of attractively priced companies with sustainable competitive advantages according to Morningstar’s equity research team.

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