While I was reviewing some of the London-listed UCITS ETFs, I chanced upon two interesting ETFs by VanEck Vectors that may be something that you will be interested to explore further.
Both these ETFs have very easy remember ticker in MOAT and GOAT respectively.
What are Economic Moats?
For those who may not realize it, my blog Investment Moats derived its name from a play of a concept called economic moats.
A moat is a water body that is deliberately dug up to enhanced the defence of a castle in the past. With this surrounding water body or moat, attacks will have a harder time bringing the castle down.
In the same way, economic moats are sustainable competitive advantages that are expected to allow companies to fend off competition and sustain profitability into the future.
This is something that good investors such as Warren Buffett often talks about. They like to buy companies that have such a wide advantage that the company can earn recurring, growing cash flows over time.
If you observe the companies Berkshire Hathaway owns, or what these super-investors own, they have some of these characteristics.
Warren Buffett likes to buy companies with these advantages and secondly, he prefers to buy these companies below their intrinsic value. This means that he has to know what the company is roughly worth and assess if the current price gives him enough margin of safety.
Now for a long time, many sought to quantify how Buffett invests. And one person at Morningstar called Pat Dorsey (he was the director of research at Morningstar for 11 years) took a keen interest in uncovering and systematizing these competitive advantages.
He eventually published The Little Book that Builds Wealth to explain in an easy to understand manner the 5 different kinds of economic moats.
Dorsey was instrumental in growing Morningstar’s equity research division and formulating Morningstar’s economic moat ratings, as well as the methodology behind Morningstar’s framework for analyzing competitive advantage.
Morningstar was able to identify companies with economic moats, assess whether the moats are wide or narrow (wider is very defensible while narrow is less).
Introducing VanEck Vectors Morningstar US Wide Moat UCITS ETF(MOAT) and VanEck Vectors Morningstar Global Wide Moat UCITS ETF (GOAT)
ETF house VanEck Vectors partnered with Morningstar, making use of their indexes, came out with ETFs that allow us to invest in a portfolio of companies with economic moats.
MOAT tries to replicate the holdings and with that, the performance of the Morningstar Wide Moat Focus Index (MWMFTR). GOAT tries to mirror the Morningstar Global Wide Moat Focus Index.
Thus, MOAT is US focus while GOAT is more global centric.
The Morningstar Wide Moat Focus Index is an equal-weighted portfolio that holds U.S. firms with wide economic moats trading at attractive valuations.
Here is a glimpse of the current top holdings in MOAT:
This ETF has a few characteristics that I like.
MOAT and GOAT are More Active than Passive
ETFs vary in a spectrum where they are more passive to some that are very active.
The factor/Smart Beta ETFs tend to be more active, but still lean towards rather passive.
MOAT and GOAT tend to lean closer to the more active approach.
The ETF leverages Morningstar’s research team’s expertise in curating companies with economic moats before deciding whether to add them to the index.
Morningstar tries to curate companies that they come across on whether they have the following moats:
- High switching costs
- Strong intangible assets
- Strong network effects
- Very low-cost advantage
- Efficient scale
I would like to think Morningstar can be rather quantitative about it but there are limitations and it would require human beings to critically think if a company has a moat and whether the moat is wide or narrow.
Investing in MOAT or GOAT is a passive way of:
- Admitting you have limitations in your ability to prospect companies with strong advantages.
- That you might not be able to cover so many companies.
- That you might not want to take on this job.
And by owning MOAT and GOAT, you have a way of investing in companies with strong advantages.
The Morningstar team also sought to continuously improve their Wide Moat index methodology. In 2016, they made some enhancements.
As a passive investor, you gain the benefit of having a team continuously fine-tuning a methodology that you may be less sophisticated in.
Your wealth benefit from their continuous improvement in a passive manner.
Morningstar’s MOAT Rating Methodology
If you are curious about how Morningstar curate the stocks and rank them, here are some screenshots of how it’s done.
I think their methodology is systematic but it allows the methodology to pick up nuances that identify companies with wide moats. This is something that is hard to scale with traditional factor-based rules.
MOAT and GOAT are rather Concentrated and Equal-weighted
Being concentrated and equal-weighted can both be disadvantaged. The hard truth is that concentration and equal weight are characteristics that have its advantage and disadvantages.
MOAT has 48 holdings while GOAT has 70 holdings.
If a fund is not diversified enough, the fund may not be able to diversify away the risks pertaining to individual companies and sectors (idiosyncratic risks). They might not be able to capture the returns of the companies that drive normal index returns.
However, the counter-argument is… you do not have to be super-diversified to diversify away from the idiosyncratic risks.
If you are too diversified, it will be difficult for you to achieve outperformance as well. We observe that to achieve outperformance, usually, the fund manager has to concentrate, and take a swing by betting on a few names.
MOAT starts with 40 stocks but because they are reconstituted in two different sub-portfolios (more on this later), they can have between 40 to 80 stocks.
GOAT starts with 50 stocks and at most have 100 stocks.
The Morningstar Wide Moat methodology used to be more concentrated in just 20 stocks (!) and they probably find that more undesirable in certain ways.
So in a 2016 enhancement, they made some changes.
This also gives you an indication that this methodology will evolve over time and as an investor of the fund you benefit from this delegation (or suffer).
The sheet above shows a summary of the recent reconstitution of MOAT. We can see that there are some stocks that were added to the index and some removed.
We also observe that there are new companies that assessed that have the potential to enter the index.
It re-emphasizes that by investing in MOAT and GOAT, you are really delegating the prospecting of business to the team behind the index.
Notice that each of the 40 stocks is reset every quarterly to 2.5% or equal weight each. Each of GOAT’s holdings would be smaller.
By being equal-weighted, it means that any stock has enough opportunity to drive the returns of the ETF. It will not be the big companies that drive the returns.
The converse is also true. If there are some stocks that doing badly, it also brings down the performance.
The table above is taken from a US-listed VanEck ETF that follows a similar methodology. This is a pure international ETF, screen for companies with a strong economic moat.
This table shows the bottom of the fund’s current holdings. Notice that they are all the China firms. There are about 3 education companies.
We all know that these firms had their share price killed recently. The MOTI ETF has not done well versus the international index.
In this case, the concentration and equal weight have killed the ETF.
MOAT and GOAT takes into Prioritize Companies with Cheaper Valuation versus their Intrinsic Value
At first, I dismissed these ETFs to be similar to the quality factor. If you identify companies with a strong competitive advantage would likely screen for companies that have the same quality factor.
This is not entirely true.
If you read Morningstar’s methodology in the sections above, they can screen for companies with greater fidelity.
What I like about the ETF is that the research team also compute the company’s intrinsic value compared to the price that it is currently trading at.
The table above was from GOAT’s last quarterly reconstitution.
Observe that there is a column showing the selected company’s price to fair value. Morningstar uses a more discounted cash-flow (DCF) style of computing intrinsic value. This is quite different from how factor funds do it. The factor funds will struggle to use something like DCF because it is quite hard to scale.
DCF has its flaws, just like most valuation metrics.
But the important thing is that the ETF is not selecting companies based on its economic moats, and neglecting what the stock trades at.
This was taken from a recent article call Delegating the work of valuation. The good thing about their valuation approach is that if certain companies exhibit that their future cash flows dramatically improves, the company remains undervalued (Google) and the fund continues to own it.
If a company shows that based on future cash flows, the company is overvalued, then the company exits the Moat Index.
In my education on factor investing, I came across the work of some factor research shops. Their common critique about fund houses is that there aren’t so many factors.
End of the day, it is how you describe what is value. Those research houses consider profitability and quality to be within the value. As long as you compute your intrinsic value well and buy the stocks that are cheap relative to their intrinsic value, history shows that you will do well over time.
The factors that did well (be it value, minimum volatility, size, momentum, quality) happens to be the factors that at the time are undervalued.
So valuation plays an important role and in this regard, I really like the combination of economic moats plus value.
The Portfolios have a Staggered Rebalancing Approach
The Morningstar index has a rebalancing approach that is seldom seen around.
To minimize costs, normally funds try not to rebalance so much. The issue with rules-based funds like this is that if after you rebalance a major event happens that dislodges valuation, your fund missed out on that opportunity and that affects performance.
Yet, sometimes we cannot rebalance so often because, for certain factors, it takes time for the premium to show up.
So the most elegant method is to split the portfolio into 12 equal slices. The fund will balance each slice per month. In this way, each slice has about 12 months to realize the premiums and yet the fund don’t miss out on certain market events.
The Morningstar Index did not do something so extreme.
The index is divided into two sub-portfolios.
Each sub-portfolio contains 40/50 stocks. One sub-portfolio reconstitutes in December and June. The other sub-portfolio is in March and September.
This gives each sub-portfolio six months to show its performance as likely, the performance decay is longer for this methodology.
Other Notable Characteristics
The ETF’s expense ratio is on the high side. MOAT is 0.49% while GOAT is 0.52%. But I think they are not too far off from the iShares Multifactor ETF that I reviewed not too long ago.
Both ETFs is domiciled in Ireland so they are more tax-efficient when it comes to estate/death taxes for Singaporeans.
Both are on the smaller size side with MOAT being USS688 mil and GOAT US$48 mil.
Liquidity can be an issue for some but I find that whenever I need to purchase the bid-ask spread ranges from 7 to 20 basis points.
Both MOAT and GOAT are also listed on the US and Australian stock exchanges.
MOAT and GOAT Performance
The history of returns for the Morningstar Index is rather short but here is the data.
Here is MOAT’s performance since Apr 2012 versus SPY, the S&P 500 ETF:
There is definitely some periods where the SP500 did better but over this long period, the Morningstar team has done well.
The annualized return is higher, but so is the volatility.
Here is GOAT’s performance since Oct 2018 versus IWDA, the iShares MSCI World UCITS ETF:
Performance for GOAT looks not too bad. What is not displayed here is for the past year, GOAT has slightly underperformed IWDA.
In one of Morningstar’s articles, they break down the performance of the US-Wide Moat Index by calendar year.
It allows us to appreciate the nature of returns.
There will be years where this methodology underperform (see that stretch of 2013 to 2015) and that is going to be hard to swallow in terms of investing experience.
The general idea is that when the premium appears, the outperformance makes up for those years when it underperforms.
How does focusing on economic moats, value, equal-weighting and being concentrated add up?
Morningstar explained in this article whether there are performance improvements when you construct a portfolio that has some elements of quality, value, equal-weighting and concentration.
In the article, they compare the performance of different sub-indices that allows us to isolate the performance of certain factors like equal weight, moat and valuation.
What we notice is that just focusing on economic moats will improve the performance over the general market index.
But over the short term, we cannot really tell whether being equal-weight and focus and value companies show clear performance improvements.
I do feel that some are worried that we may lose out on return by being very concentrated and this result show that in this time period, it probably doesn’t affect performance that much.
How does the Wide Moat Focus Index show up in terms of Factors?
You may be curious that since focusing on economic moat does sound like a quality screen, how does the methodology look when viewed in the traditional factor lens.
Morningstar’s article shows us some interesting results when we try to decompose it this way.
- Tilts towards value more than growth.
- More high yield than low.
- Low exposure to momentum than the market-cap indexes.
- Surprisingly lower than average on the quality spectrum!
- Lower than historical volatility.
- Less liquid.
In a certain way, these factors point to a portfolio that is likely to be lower in volatility and more defensive.
Here is Morningstar’s explanation of the difference between traditional quality and their methodology:
If there is one takeaway from this, it is that Morningstar has provided quite a lot of materials that make their methodology less opaque. You can go to VanEck Vector’s US site, go to MOAT or GOAT and go to the documents section.
This is something a lot of investors would understand and be comfortable with: Invest in companies with competitive advantages that are unassailable, at cheap valuations.
The question is how do we do this in a systematic manner.
GOAT and MOAT are not for everyone.
But for the individual stock investors struggling to be sophisticated enough to do this well, owning GOAT or MOAT might be an easier way to live.
If you’re looking to trade these stocks I have mentioned, you can open an account with Interactive Brokers. Interactive Brokers is the main low-cost and efficient broker I use and trust to invest & trade my holdings in Singapore, United States, London Stock Exchange and Hong Kong Stock Exchange. They allow you to trade stocks, ETFs, options, futures, forex, bonds and funds worldwide from a single integrated account.
You can read more about my thoughts about Interactive Brokers in this Interactive Brokers Deep Dive Series starting with how to easily create & fund your Interactive Brokers account.
I do have a few other data-driven Index ETF articles. These are suitable if you are interested in constructing a low-cost, well-diversified, passive portfolio for yourself.
You can check them out here:
- IWDA vs VWRA – Are There Significant Performance Differences Between the Two Low-Cost ETFs?
- The Beauty of High Yield Bond Funds – What the Data Tells Us
- Searching for Higher Yield in Emerging Market Bonds
- Should We Add MSCI World Small-Cap ETF (WSML) to Our Passive Portfolio?
Here are some supplements to sharpen your edge on low-cost, passive ETF investing:
For those who wish to do better, believes that certain factors such as value, size, quality, momentum and low volatility would do well over time and are willing to harvest these factors through ETFs and funds over time, here are some articles to get you started on factor investing in a passive manner:
- Introduction to factor investing / Smart Beta investing.
- IFSW – The iShares MSCI World Multi-factor ETF
- IWMO – The iShares MSCI World Momentum ETF
- Investing in companies with strong economic moats through MOAT and GOAT.
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