Why the MOAT ETF Is Performing So Well

The moat is an analogy used by legendary investor Warren Buffett to describe the durable competitive advantages some companies enjoy. But can investors use moats to generate higher returns? Brandon Rakszawski, director of product management at VanEck, sits down with etf.com Senior Analyst Sumit Roy to discuss why investing in companies with moats makes sense.

Sumit Roy: Hi, this is etf.com's Exchange Traded Fridays podcast, a weekly podcast covering developments in the ETF industry. My name is Sumit Roy, and I'm senior ETF analyst for etf.com.

This week, I'm talking with Brandon Rakszawski, who is director of product management at VanEck, an ETF issuer with nearly $60 billion in assets under management within its U.S.-listed ETFs. Brandon, welcome to the show.

Brandon Rakszawski: Thanks so much for having me. Great to be here.

Roy: Great to have you. So, Brandon, I want to talk about a very popular ETF of yours, and that is the VanEck Morningstar Wide Moat ETF (MOAT). It has $9.4 billion in assets under management.

But this isn't an ETF that gets discussed a whole lot. But if you look at the performance, maybe it should, right? It's beaten SPY over the past one year, over the past three years, five years, and since inception over 11 years ago.

I want to get into how the ETF works. But before we get there, can you talk about this concept of the moat? That's a term coined by Warren Buffett, isn't that right?

Rakszawski: That's right. And Morningstar, who is really the brains, the power behind the underlying investment strategy, took that concept and ran with it.

They've essentially woven this concept of identifying economic moats, so these barriers to competition around a company's business model and trying to find those companies that have not only a moat, so a way of defending their profits from competition, but also those that can sustain those moats in very far into the future.

And that's really the center of Morningstar's equity research philosophy and everything that they put into their equity research of all of the 1,500-plus companies they cover globally.

It serves as the foundation for the Morningstar Wide Moat Focus Index, which is the index that our MOAT ETF tracks. And it's a pretty straightforward concept.

If a company is successful and they're becoming profitable, that attracts competition. That's capitalism 101.

And those companies that can set themselves apart by creating some sort of advantage over their peers to fend off competition can be set up for success well into the future.

So, Morningstar's equity research analyst team is looking at every company that they cover and trying to determine which of those companies have some sort of advantage. They've got a very robust, systematic framework for assessing all of the companies that they cover.

They essentially assign each of those companies a moat rating. And those ratings imply whether or not a company has a competitive advantage and also how long Morningstar believes that company can sustain a competitive advantage.

So those ratings go from wide to narrow and to none. And that just simply implies the size of a competitive advantage, and also the duration and sustainability of that competitive advantage; so, a very exclusive list of companies in the U.S. receive the wide moat rating from Morningstar's equity research team.

And those are those companies they believe can sustain their competitive advantage for 20 years or more into the future. So, a very exclusive rating from that team.

Roy: Sounds like a very compelling strategy. Obviously there are a lot of different types of moats. Can you talk about some of them, Brandon? Maybe, network effects, I've heard. What else is out there?

Rakszawski: That's right. So Morningstar, as part of this moat research process, has identified five different sources of economic moats. And they're all very logical, but they're also hard to establish. So I can walk through those very quickly.

First is switching costs. The first sort of source of moat being switching costs, that's when a company has entrenched themselves, their products or services so much into their customers business model that it's both costly and time-consuming for their customers to switch from one service provider to another.

In our everyday life, you can think about banking, for example. To go and close your bank account at one bank and then go have your money transferred to another bank to open a new account can be burdensome. So banks sometimes often benefit from a switching cost source of moat.

The second source of moat is intangible assets. That's been a buzzword, I think, in the investing community for quite some time. When a company can create an intangible asset source of moat, they can create some sort of brand or they may have been able to obtain a patent in the pharmaceutical industry.

And these intangible assets allow them to charge more for their good or service than their competition. Starbucks is a great example of this. With their brand, they're able to charge just a little bit more than any other coffee retailer on the same block.

The third source of moats as identified by Morningstar is network effect. The network effect can be very powerful. It's when the value of a good or a service increases when more users are involved with that good or service.

So we see this happening in one obvious area with Meta platforms and their Facebook social media platform. The more users, the more powerful that network becomes, and the more advertisers might be willing to spend on that platform.

It also exists in credit card companies, for example. So the more merchants that accept the Visa card motivates more consumers to go out and open a Visa card. And the more consumers that have a Visa card, the more merchants are going to be likely to accept Visa cards. So that network effect can really benefit a business.

The fourth source of mode is cost advantage. That's pretty straightforward. You can think of Walmart or other businesses like that where, when a company can create this cost advantage, they can either undercut their competition from a price perspective or they can be more profitable at the same price point. So the cost advantage being the fourth source of moat.

And last, but not least, probably the least common source of moat, is efficient scale. You can think of this as somewhat of maybe a regional monopoly. Efficient scale exists when a certain market is really efficiently served by one or very few participants.

So the motivation to enter a market as a new entrant is very low, because it's essentially going to reduce profitability and returns for all participants. So you can think of maybe a regional rail operator, Union Pacific or name the rail provider.

They're not going to just go lay track in a new territory if there's already an extensive rail line network in that area. So it's a bit of a barrier entry or a natural monopoly.

Those are the five sources of moat: switching costs, network effect, intangible, asset, cost advantage and efficient scale.

That's what Morningstar is looking at with each of their companies to identify whether it has one of these sources of moat and then therefore an advantage over its peers. And then just as important, it looks forward and determines how long it can sustain these sources of moat into the future.

Roy: Super interesting stuff; great color, Brandon. Now turning back to the ETF, you already talked about this a little bit. How does the MOAT ETF works? It's an index-based fund, so it replicates that index and based on Morningstar's methodology, is that correct?

Rakszawski: That's right. The ETF is tracking the Morningstar Wide Moat Focus Index. And that index is looking at the universe of U.S. companies and selecting from those that Morningstar has assigned a wide moat rating to; so, as I said, the most exclusive subset of Morningstar's equity coverage universe.

And I think it's important to note here that Morningstar is a large organization. I think most folks listening to this podcast probably have heard of Morningstar. They've got a great research area, funds, mutual funds, ETFs, they've got a great data capability.

But they also do have a very extensive and well-accomplished equity research division. And that's really where we're getting all of the underlying equity research that powers our MOAT ETF and its underlying index.

Morningstar's equity research team has over 100 equity research analysts globally covering 1,500 companies globally. They're spread across different regions of the world and churning out equity research on all of these companies. So this index is created leveraging the output from these equity research analysts.

You can almost think of the index as a client of Morningstar's equity research. It's just consuming the economic moat research that it's putting out to assemble the portfolio.

What the ETF and the index use in addition to these moat ratings is Morningstar's fair value estimate for these companies that they cover. Because logically, if you think about these great companies, high quality companies with sound business models protected from competition into the future, everyone's going to want to own these types of companies, right? So they very rarely will trade on sale, if you will.

So the goal of the index strategy is to leverage both the moat research provided by Morningstar's Equity Research team, but also leverage their fair value estimate, which is their valuation metric, to allocate to those wide moat companies that are trading at attractive valuation relative to the universe of wide moat companies.

So on a quarterly basis, the index undergoes a very systematic prescheduled review process in which it assesses the U.S. equities with wide moat ratings and then allocates to the cheapest or the most attractively priced of those companies based on where their stock price is currently trading, relative to how much Morningstar's Equity Research analysts think the company is worth. So that is what really drives the selection process on a quarterly basis.

And then the ETF and the underlying index are targeting approximately 45 to 55 companies from that universe. That's generally the range in the holdings, anywhere from 45 to 55 of the most attractively priced wide moat companies at any given time.

And this combination of targeting these high quality, moat-rated companies and using valuations to drive the selection process has been this winning formula that's really driven some of the success of this ETF over the last 10-plus years, not to mention the underlying index has been live since 2007.

So we're not talking about a back-tested strategy that's kind of been reverse engineered to work historically. It's proven itself in real time.

Roy: Brandon, I'm glad you mentioned valuation, because I did notice that Nvidia currently isn't included in MOAT's portfolio. To some people, that might actually be a surprise, right? Because obviously Nvidia is a leader when it comes to designing the chips that power AI applications. Why isn't that a holding in the ETF?

Rakszawski: Nvidia is not a holding in the ETF because it's too expensive right now, and it has been for a little bit of time.

So, like I said, a lot of great companies are owned by a lot of investors that can drive their price higher and higher. And Morningstar, independent of market sentiment and momentum and all of this, they assign a fair value estimate for each of these companies.

Because of the systematic, rules-based way that this index is constructed, if a company is overvalued, it's most likely not going to be added to the index. You saw that with Nvidia for a good portion of its recent history. The last 10 years or so, Nvidia was generally not in the index.

However, in 2022, as a lot of growth-oriented companies were struggling through the inflationary environment and then the subsequent Fed action that raised rates, Nvidia actually did flash a little bit of evaluation opportunity, and it was added to the portfolio in September of 2022.

This kind of story plays itself out again and again with different companies. We could go down the list. Meta Platforms, for example, has been very kind of opportunistically added and removed from the portfolio historically.

But back to Nvidia, it was added in September of 2022 because it flashed a discount to Morningstar's Fair Value for really the first time in years and years. So it was added to the index. And it has since performed, as everyone is aware, very strongly.

It was actually removed from the portfolio in March of 2023 after appreciating significantly while in the portfolio. So it ended up missing some of that rally after its more recent earnings results and forecast revisions, but participated in a pretty strong way.

And despite Nvidia not being a consistent holding of MOAT, and despite other companies that you might be surprised to learn that have not always had a wide moat rating, like Apple, for example, it was just recently, in the last six months or so, upgraded from a narrow moat rating to a wide moat rating.

The MOAT ETF won't hold many of those big megacap tech companies that we're all used to hearing about that drive market returns. It will be underweight or simply not allocated to some of those companies.

And the performance of the strategy is in many ways, despite that underweight, as opposed to a beneficiary of its exposure to some of those really high-flying companies we've seen over the last 10 years or so.

Roy: I should mention that despite excluding Nvidia, currently MOAT is up almost 21% year to date, which is well in excess of the S&P 500’s 15% return. So what kind of stocks are in the ETF currently that are driving it? I know Meta is in there currently. What other wide moat stocks are in there?

Rakszawski: It's been interesting. Trends will play out within the underlying index and the ETF MOAT. As the index is systematically reconstituted and rebalanced on a quarterly basis, we'll see shifts in the portfolio, if you will.

The sector allocations can change pretty significantly from quarter to quarter because again, this is really unconstrained. It's simply a strategy that targets wide moat companies; first criteria, second criteria, they have to be attractively priced.

So as you see certain segments of the market flash valuation opportunities, you'll see some exposure enter the portfolio. And that played out postpandemic in 2020. We saw the portfolio really shift to more of a value posture, and it did so a little bit ahead of the trend there, and it eventually benefited from that value exposure.

And then as everyone started to become attracted to the consumer cyclical stocks and the more defensive areas of the market, the index actually started to scale back and return to more growthier areas of the market. Tech and others started to see more prominence in the portfolio throughout 2022 as that sector became beaten down, if you will.

Now we're starting to see kind of a reversal of all of that. We're seeing some of those growth names, some of the profits being taken in some of these companies.

And we saw recently, actually last week, the index went through its most recent review, and we saw a little bit of a shift away from growth and back more into that core and slightly more toward value exposure that we're seeing currently.

So in terms of current companies that you see in the portfolio, there are the usual suspects you're not going to be surprised have a wide moat rating that are being held by the portfolio; companies like Google of course, and salesforce.com has a very strong moat from the tech sector.

You see companies across the healthcare, pharmaceuticals, biotech and maybe some medical device companies. So you'll see companies like Zimmer Biomet in the portfolio straight through to banks and consumer-facing companies like Kellogg, US Bancorp, and Bank of America and others.

But there are also some unique names, some lesser-known companies that Morningstar covers that you might not find in your typical fund or ETF: a lot of chip companies that are not actual chip manufacturers but are involved in the manufacturing process; quality and control companies that are part of that semiconductor ecosystem straight down the line. So, a lot of interesting names.

I encourage you to check out the holdings of MOAT because it is a heavily followed ETF in terms of what's being held by the ETF and when. We do get a lot of traction around these quarterly repositionings to see where the valuation opportunities are at any given time.

Roy: That's great. So Brandon, I know MOAT isn't your only ETF focused on investing in companies with competitive advantages. Can you talk about some of the other ETFs in your lineup?

Rakszawski: So we launched MOAT back in 2012. It's really our flagship ETF, and one that has done very well and spurred a lot of demand from our own clients for other exposures to Morningstar's moat research methodology in different regions or market cap ranges.

Shortly after we launched MOAT, we launched an international version. So basically, global ex-US, the VanEck Morningstar International Moat ETF (MOTI), or MOAT international. That's been very successful this year, in addition to the success we've seen with new investment and returns from our flagship MOAT ETF. MOTI, our international offering has also been very popular.

And then one other ETF that we're very excited about here is our small and midcap version, the VanEck Morningstar SMID Moat ETF (SMOT), targeting U.S. companies in the small and midcap section of the market that have moats and are attractively priced.

We're very excited. We received a lot of feedback from our existing investors in MOAT that they would love to see this type of methodology applied down market cap, and we think the timing is really very opportunistic for looking into that type of exposure right now.

The small and midcap areas of the market have underperformed for quite some time. It's had a tough go this year, as there's a lot of concern in the market about a potential recession in the future, and small caps generally will underperform leading into recession, but they'll often historically recover more rapidly in a bigger way than large caps subsequently in the recovery phase.

We're seeing these valuation dynamics of large versus small and midcap stocks right now that haven't really played out for decades. The valuation story is really compelling for taking a look at and considering small and midcap stocks. So we're able to apply that MOAT methodology to the small and midcap space right now with SMOT, and we also offer ETFs for global MOAT exposure.

There's an ESG-focused U.S. MOAT ETF, the VanEck Morningstar ESG Moat ETF (MOTE), and that rounds out our offerings at VanEck, but we've got a pretty comprehensive suite of ETFs fueled by Morningstar's equity research team.

Roy: Fantastic. So before I let you go, Brandon, is there anything else you want to add?

Rakszawski: Just something that we've monitored quite a bit here at VanEck, and we've heard a lot from our clients about is uncertainties in the market.

This focus on high quality stocks really just obviously blends right into our conversations we're having with MOAT, based on the efforts of Morningstar's team to identify high quality companies with competitive advantages.

But we've seen a lot of investors gravitate to quality index single-factor ETFs, which has been really fascinating as markets have appreciated this year after a very difficult 2022.

Despite some of that rally and recovery, there's still a lot of interest in these well-positioned, sensible companies to weather some of the market uncertainties moving forward.

I think it's very difficult to time factors. I think we've all learned that whether it's value, dividend, yield, low vol, it's very difficult to get that timing right.

We’ve had a lot of positive reception to MOAT and its effort of identifying these high quality companies with defensive characteristics, but also focusing on the valuation side.

So I think what a lot of these factor-oriented strategies can be missing is they might target a factor, but timing that factor is so difficult that having a valuation-driven selection methodology has added so much value to the MOAT ETF and its underlying index.

Historically, that's one thing investors shouldn’t lose sight of: making sure you're not overpaying for the exposure that you're getting. And that's really something I try to hammer home when I can.

Roy: That's great. Well, we're going to have to leave it there. Brandon, thank you so much for coming on the show and sharing your insights with us.

Rakszawski: Awesome. Thanks for having me. I really appreciate it.

Roy: Listeners, I hope you enjoyed this episode. You can find this and all other Exchange Traded Fridays episodes on etf.com or on any major podcast platform. See you next week.