The ETF That Coined Buffett’s “Moat” Factor

Warren Buffett coined the word “moat” in investing – he looks for a company that has a protective moat around a valuable castle. Now ETF provider Van Eck Global is further capitalising on this concept by bringing its successful U.S.-listed ETF, which applies this moat theory to its underlying index, to launch in Europe.

The $1 million Market Vectors Morningstar US Wide Moat UCITS ETF (MOAT) listed in London on 28 October with annual costs of 0.49 percent. The physically replicating fund tracks an index of 20 U.S. stocks and aims to gather the same traction of its U.S.-listed counterpart, which launched in April 2012 and now has around $800 million of assets.

ETF.com speaks to Lars Hamich, chief executive officer of Van Eck Global (Europe), and Alex Morozov, director of European equity research at Morningstar, about what the moat theory is and why it could be interesting for European investors.

ETF.com: Your Morningstar index looks to assign a rating to each company – whether it has a wide or narrow “economic moat”. This approach seems to be quite similar to “quality”, where companies are selected depending if they have sustainable cash flow and dividends. What’s the difference here?

Alex Morozov: We want to find a number of businesses that manage to protect their castles – create excess returns – by creating a moat around it, i.e. benefitting from structural advantages. That is, in some ways, similar to the traditional “quality” but that is a very all-encompassing word that I’m not sure is the same as economic moat – a quality company doesn’t need to be a company that benefits from a structural advantage.

General Motors is a quality company but there is no “moat” as there is no structural advantage in place. We are looking for sustainable and durable advantages. Will the company have those for the next 15 to 20 years?

That’s really what we try to achieve through our methodology.

ETF.com: What are the examples of these structural advantages?

Morozov: There are several factors to consider. One is called “intangible assets”. Look at [pharmaceutical company] Merck: that company benefits from patents. Or a luxury company like Hermes or Burberry, which have a very strong brand and for which consumers are willing to pay extra.

“Switching costs” is another one. Look at Oracle – it would cost a lot of money to take out the Oracle system and replace with a competitor. Are the time and resources worth the switch?

Then there is the “network effect” – look at Facebook or Mastercard. There is a powerful cycle whereby customers carry Mastercard because it is accepted by merchants and the merchants accept it because customers carry it.

There is also “cost advantage” and “efficient scale”.

ETF.com: The traditional ETF index, market capitalisation weighting, relies on hard numbers to decide on which companies make the cut. But the moat scheme seems to have more discretion involved.

Morozov: Our approach is much more qualitative. We found out that size was not a factor for a moat company. A lot of the top companies in the S&P 500 do not have economic moat. Yes they are large and have market share but market share doesn’t mean moat.

Again, I refer to General Motors: It’s in a very difficult industry. The company could be a leader, like Volkswagen, but its market share doesn’t mean it’s the best position in terms of being able to protect itself from variable market conditions like swings in demand.

On the flip side, you can have small and medium-sized companies with a wide economic moat as they dominate their space and they are robust. Investing in moat companies reduces the overall risk of the portfolio. These moat companies, we found, are 2.5 times less likely to cut dividends, whereas other companies are 53 times more likely to declare bankruptcy.

The S&P 500 is considered a safe product, but moat companies’ cash flows and the quality of business itself is much more predictable.

We don’t just select companies with a wide economic moat, but we select those that are the cheapest – that combination results in significant alpha.

ETF.com: How has this strategy performed?

Lars Hamich: This index has a long history. It’s real, not back tested. Over the last eight years we can see the outperformance.

We are going through a phase where MOAT underperformed through the higher earnings cycle but in the long run it outperformed consistently.

For me, there is a question mark behind the quality of the data with smart beta funds as they have shorter track records and you know more today than you did yesterday. This is not the case with our fund. [The index went live in April 2007.]

There are still a lot of flows into U.S. equities even if some people view it as expensive.

[The U.S.-listed ETF has returned minus 1.64 percent over the last 12 months, compared to the S&P 500's 6.92 percent].

ETF.com: Does the quarterly rebalancing of the ETF affect turnover?

Morozov: The turnover is higher relative to other ETFs that rebalance less frequently. But we are focused on long-term structural advantages. This index is a combination of quality and valuations. And valuations change. Some of the names that didn’t appreciate one quarter could go up the next. Every quarter we select the 20 cheapest stocks.

Hamich: The fund is quite aggressive in that sense. If you are not among the 20 cheapest stocks, you won’t make it [into the index].

Some people believe in investing in the big names, and look back at their choice in five years’ time [to check valuations]. But by applying our strict methodology, you are always guaranteed the cheapest stocks. That’s why we weight stocks equally in the index, because its moat factor and valuation are more important than size.

ETF.com: As for Van Eck Global, this is your third ETF in Europe after the launch of two gold funds this year. What are your future plans in Europe?

Hamich: The next two or three products will be existing U.S. funds but sometime next year we will launch our own European funds.