Archive for August, 2012

ETFs Get Sillier with Morningstar Moat Index

August 29, 2012 2 comments

So we all know that Warren Buffet has been talking about economic moats for, like, decades now! Although he strongly recommends that most investors buy simple index funds, some clever people are trying to do as he does, not as he says. On Andrew Hallam’s excellent blog I recently heard about the MOAT ETF, which promises to invest in businesses with a wide moat. It even got a write-up in the WSJ this month calling it a way to follow the Buffet Strategy. As it turns out, this might be the old strategy of handing your money over to Buffet because he’s way smarter than you.

I was very curious when I heard about this so I took a look. It turns out the Morningstar (which may be single-handedly responsible for most of the performance-chasing harming mutual fund investors) has recently create an Economic Moat Rating for companies, and an associated index of companies with a wide moat. Sounds like a good idea, right?

To start with the factors in the rating aren’t too impressive. The 5 factors are Intangible assets/brands, Switching costs, Network effect, Cost advantage, and Efficient scale. Not bad overall, and it’s true that those do make it difficult to compete. But which generic stock analyst isn’t already looking at these? There’s nothing new here and in fact it’s cutting out a lot of material factors. No one has ever been impressed by a company that only wins by having prices $0.01 lower than the competitor!

Some of the sample classifications in a document published by the ETF manufacturer seem a bit off. For example, Oracle and Salesforce are classified as having wide and narrow moats respectively because of switching costs. Which is a bit backwards. I switched databases on a system earlier this year in 15 minutes, because the new one was 100% compatible with the old one. True, Oracle is a monster and would it would take some work to be mostly or fully compatible. But I think a few years of software engineering is a lot cheaper than a head-on marketing assault on an entrenched brand. And its complexity means that there could be a lot of cost savings from switching. The company does have a wide support network that most competitors can’t match, so maybe it falls under network effects.

On the other hand, an organization that really uses would have to do a huge amount of work to rebuild their data and processes around a new system, not to mention potentially slowing down their sales while they change (now that will give stock analysts are heart attack). How’s that for a “narrow moat”? And they say FedEx has a narrow moat because of cost advantage (behind UPS), ignoring the branding. It’s not that long ago that I could hardly name a FedEx competitor. They even have major movies made about them (and a volleyball with a face)!

Finally, the ultimate sin comes with one little line: “The index comprises the 20 stocks with a wide moat that are trading at the largest discounts to our analysts’ fair value estimates. The index is reviewed on a quarterly basis”. It’s not really an index, it’s actively managed. And it’s not really actively managed because a reaction takes 3+ months instead of the hours most managers need to start dumping a stock they don’t like.

So the index, and the corresponding ETF, are just active management that is very slow to respond. The right way to do this would be to have an index of all companies that fit the criteria, and then let investors decide if that index as a whole is overpriced or underpriced. Next time people really freak out about stocks I would love the chance to pick up a basket of strong businesses in one order. But this ETF isn’t the way. It sounds like the index was built by saying “Warren Buffet owns shares in Coke” and working backwards from there. Which means that everyone buying it is driving up the value of Buffet’s holdings.

In the end this is just the same old active management, promising to buy good stocks cheap, under a new name. There is one really impressive move though. I haven’t look at expenses on other active ETFs, but with an MER of 0.57% on this it’s a step in the right direction of doing less harm to ordinary investors. If other active managers get their fees low enough they might even keep up to us indexers one day!


The Death of the Cult of Bonds

August 25, 2012 Leave a comment

By now everyone has heard of Bill Gross’ comments about the likely decline of equities, and everyone has heard the explanation for why his math is wrong. I don’t believe that Gross’ letter was anything more or less than a marketing piece designed to attract people who want to dump stocks and buy bonds. Surprisingly he does mention in passing towards the end that we have to lower our expectations for bonds.

Since the early 80s, interest rates have gone from record highs to record lows. Based on the simple math of markets, this has created a bull market for long-term bonds that lasted even longer than the run for stocks (which started a few years after the last time the media announced the death of equities).

Which brings us to today. If falling interest rates create rising prices for long-term bonds, and interest rates are at record lows, who wants to buy bonds? Apparently quite a few people do since this is what keeps the interest rates down. When the supply of willing buyers dries up, issuers will be forced to raise interest rates to keep borrowing as parts of Europe are demonstrating for us.

However this is a case where I disagree with the market, or at least have a different situation. I’m confident enough in our other assets and our future income that I don’t feel the need to get marginal safety at any price, even the negative nominal yields you can get in Europe. Which leads me to ask why I would want to hold a lot of bonds.

Since we still manage a simplified portfolio using only 4 index funds, our bond allocation comes from the DEX universe index which has an average term of around 9 years and duration of around 6 years. This carries a fair bit of exposure to rising interest rates, and pays very little at the moment. Last time I did a comparison it was less than the dividend yield on some of the stock indexes we use. If both the immediate and the future expected returns are higher on stocks, I will take those.

I have stopped all bond purchases, and the allocation has drifted down to 5% of our portfolio (with another 1/3 of that amount in a Mortgage Investment Corporation that actually has an interesting yield and a term under 2 years). I would dump this altogether but since stocks aren’t at irrational lows now they could fall a bit more and the bonds could provide some useful buying power. This would take something big of course.

At this point stock investors seem to be pricing in bad news that is only theoretical, so even announcements of new trouble could lead to a rising stock market if they aren’t as bad as expected. Since we are still rapidly adding to our stock portfolio I get excited every time prices fall. At this pace it will take 26 months or less to double our portfolio through contributions, so that is still similar to having a large bond/cash allocation that we will move into stocks.

There is one area where you can be a double-contrarian though. If everyone is avoiding duration because they recognize the risk of rising interest rates, maybe it is priced right or even cheap. And if you do want fixed income, maybe you can get some better interest rates without a lot of risk by going for medium or long terms.

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