ETFs Get Sillier with Morningstar Moat Index
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 salesforce.com 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!