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Fund Moat Ratings and the Bear Market

Wide-moat funds were the stars of the recent downturn.

David Kathman, CFA, 10/18/2011

Back in December 2008, near the depths of the financial crisis, we took a look at average economic moat ratings for mutual fund portfolios and how those ratings correlated with fund returns in that year's market collapse. Morningstar stock analysts assign a moat rating to every stock they cover, representing the strength of its competitive advantages, if any. A wide-moat company (such as Wal-Mart WMT or Coca-Cola KO) has strong competitive advantages that keep competitors at bay; a narrow-moat company has less-compelling advantages; and a no-moat company lacks such advantages, making it tougher to hold off potential competitors and maintain long-term profitability.

In that article, which you can read here, we found that funds with the highest asset-weighted average moat ratings tended to be among their category's best performers over the previous 12 months, a period that included the worst of the 2008 bear market. This makes sense, because most investors were looking for safe havens during that time of fear and uncertainty, and wide-moat stocks tend to be very stable and predictable. Conversely, funds with the lowest average moat ratings tended to be among their category's worst performers over the same period. (We found similar correlations for funds' average fair value uncertainty ratings, which measure how confident our analysts are in the fair value estimates they assign to a stock.)

The recent market swoon that began in late July hasn't been quite as bad as that of late 2008 to early 2009, but it has also resulted in a lot of fear, uncertainty, and stampeding into investments perceived as being safe. Does that mean that funds with high average moat ratings have again outperformed? To answer that question, we looked at the "Average Moat Rating" data point that Morningstar now calculates for most equity funds, available in the Premium Fund Screener and several other Morningstar products. Funds get one of five ratings depending on their weighted average moat rating: "Wide" for the highest group, followed by "Moderate" (or "Moderately Wide"), "Narrow," "Minimal," and "None." Funds get a rating only if at least 50% of their assets are in stocks with a moat rating.

We sorted all large-cap domestic-equity funds into groups based on their Average Moat Rating, then looked at the average percentile ranking for each group's funds during the third quarter (July 1 through Sept. 30), which included the worst of the recent market decline. These percentile rankings range from 1 (the best) to 100 (the worst). The following table shows the number of funds in each group and their average three-month percentile ranking as of Sept. 30; there are no domestic large-cap funds with an average moat rating of "None," so that rating is not included.

The relationship here is remarkably linear--the wider a fund's moat rating, on average, the better it performed in the third quarter. Funds with a wide average moat rating ranked in the top 12% of their category, while those with a minimal rating ranked in the bottom 10%. An amazing 36 out of the 46 funds in the wide group ranked in their category's top decile for the quarter, while 18 out of the 23 minimal funds ranked in the bottom decile. (The wide group would have an even lower average ranking if not for Rydex Dow 2x Strategy RYCYX and ProFunds Ultra Dow UDPIX, which ranked in the 99th percentile for the quarter. They're designed to generate twice the return of the Dow Jones Industrial Average, so in a bear market like this one their losses are magnified.)

The funds in the wide group hold primarily big, stable blue-chip stocks, and they tend to be heavy in defensive sectors and relatively light in highly cyclical ones. The biggest fund in this group by assets is also the one with the highest average moat rating, GMO Quality III GQETX. Its portfolio consists almost entirely of consumer defensive, health-care, and technology stocks such as Johnson & Johnson JNJ, Philip Morris International PM, and Microsoft MSFT; it holds no basic materials stocks and almost no financials. Other prominent funds in this group include Yacktman YACKX, Yacktman Focused YAFFX, and Vanguard Dividend Growth VDIGX. All have similarly blue-chip-oriented portfolios, and all ranked in their category's top 5% last quarter.

By contrast, most of the funds in the minimal-moat group are heavy in cyclical and/or commodity-based stocks, whose performance is driven to a large extent by the broad economy and other external factors. One of the more prominent funds in this group is Ken Heebner's CGM Focus CGMFX, which currently has two thirds of its assets in consumer cyclical and energy stocks such as Priceline.com PCLN, Ford Motor F, and National Oilwell Varco NOV, as well as a big stake in Chinese Internet firm Baidu BIDU. For the most part these were not good places to be in the third quarter, when the fund lost 24% and trailed 98% of its large-growth peers. Another big name in this group is the $3 billion Fidelity Independence FDFFX, which is more diversified by sectors but has more than one third of its assets in no-moat stocks such as United Continental Holdings UAL and CF Industries CF. It lost 22% for the quarter, just barely better than CGM Focus.

Of course, such trends don't last forever. As the market has bounced back in the first half of October, several of the minimal-moat funds have been among the best performers in their categories, while many of the wide-moat funds have lagged their peers. That's similar to what happened in 2009, when the market finally rebounded from the depths of the financial crisis. Six months into the rally, we found that funds with the widest average moat ratings had been among their categories' worst performers, while those with the lowest moat ratings had been among the best. (You can read that follow-up article here.)

Funds with wide average moat ratings aren't inherently good, nor are those with low average moat ratings inherently bad. The wide-moat group includes some excellent funds with strong 10-year records (such as Yacktman and Vanguard Dividend Growth) but also some stinkers with poor or mediocre 10-year records (such as Midas Magic MISEX). Similarly, the minimal-moat group includes some funds with 10-year returns near the top of their category (CGM Focus) and others near the bottom (Rochdale Large Value RIMVX). The big difference is that the wide-moat funds have been much less volatile as a group and thus tend to have better risk-adjusted returns; that's why they have an average Morningstar Rating of 3.54 stars, versus 2.35 stars for the minimal-moat group. And as we've just seen, wide-moat funds perform much better in bear markets, so they're a good place to be (all else being equal) if the thought of a downturn gives you the jitters.

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David Kathman, CFA, is a senior fund analyst with Morningstar.
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