Five 'Moaty' ETFs to Fortify Investors' Portfolios

The euphoria of the stock market's three-month rally is wearing off. Over the past several months we've witnessed investor sentiment shift from fear of being invested in the market to fear of missing the rally and back full circle again to fear of being long the market. Concerns weighing on the minds of investors include the possibility of rampant inflation, a tapped-out consumer, relatively tight credit conditions, and rising unemployment. Interestingly, as the market's rally has sputtered, the CBOE Volatility Index, or VIX (commonly referred to as the market's fear gauge) has been steadily decreasing. In fact, at a level of 25.64% on June 29, the index is about half of where it stood on March 9--the current low of this market cycle.

At Morningstar, we're not market-timers--far from it. But, at the same time, we're cognizant of the market environment and not about to get lulled into a state of complacency just because the market rallied for a few weeks. Neither should you.

Understanding the emotional tug of war facing investors at this juncture, we decided to come up with a short list of exchange-traded funds that we think could serve as the cornerstone of the equity portion of investors' portfolios. Our goal was to uncover ETFs that could stand up to a "new normal" investing climate characterized by slower growth, higher inflation, and increased government involvement.

While there's a tremendous amount of uncertainty surrounding the potential for unintended consequences stemming from government policy, inflation seems to be the issue at the top of most investors' minds recently.

In our view, worries about excessive inflation are warranted--over the course of a few months, the Federal Reserve's balance sheet has exploded to well more than $2 trillion from about $870 billion in September 2008 (before the crises swung into full gear). This marks an unprecedented increase in the money supply. Still, the velocity of money remains subdued, and it's anyone's guess when the wave of inflation might actually strike. Will it be next year? Three years from now? Five years?

In any case, we take comfort in knowing that stocks have traditionally been an excellent hedge against inflation. (Of course, diversified portfolios will contain other asset classes that should do well through inflationary periods--namely, commodities and Treasury Inflation-Protected Securities.) Over the long run, stocks have proved their ability to outpace inflation. However, rather than just "buying the market" through investing in the  SPDRs (SPY) or  iShares S&P 500 (IVV), we think that investors can benefit from being more selective.

In short, we think that investors would do well in owning shares of companies with pricing power, strong brands, bargaining power over suppliers, and solid balance sheets. Morningstar readers are well aware that such competitive advantages often translate into economic moats. Morningstar's team of equity analysts cover more than 2,000 stocks, and we can tap into our colleagues' qualitative assessments of firms' competitive positions within their respective industries and provide an bottoms-up evaluation as to the "moaty-ness" of a basket of stocks in an ETF.

Our search was fairly simple: We screened for ETFs that have the lowest percentage of no-moat stocks and at least 94% coverage by our equity analyst staff (in order to ensure the integrity of the results). See the results in the table below. Coincidently, the screen also produced the ETFs with the lowest percentage of high, very high, and extreme fair value uncertainty ratings. To perform a customized screen, we encourage readers to experiment with our new ETF Screener Beta; however, do note that screening criteria such as price/fair value, uncertainty ratings, and percentage of analyst coverage are only available to Premium Members of Morningstar.com. (Start a free 14-day Premium Trial Membership by clicking here.)

Five Moaty ETFs
	Price/ Fair Val	Economic Moat %	% of Assets with FV	Fair Value Uncertainty %
		Wide	Narrow	None		Low	Medium	High	Very High	Extreme
Rydex Russell Top 50 (XLG)	0.75	67.94	31.15	0.66	100	39	38	15	3	5
SPDR DJ Global Titans (DGT)	0.77	50.36	40.92	2.23	94	29	44	9	6	6
DIAMONDS Trust, Series 1 (DIA)	0.75	70.02	27.11	2.70	100	51	33	7	4	5
Vanguard Dividend App ETF (VIG)	0.80	61.59	30.64	3.40	96	46	34	11	5	0
iShares NYSE 100 Index	0.75	53.44	42.49	3.61	100	32	43	15	4	5
SPDRs (SPY)	0.76	45.59	44.11	9.24	99	22	45	21	8	4

Because these ETFs could be considered core equity holdings, we'd urge would-be investors to consider the sector exposure that each of these ETFs provides. In the table below, we've stacked each of the funds up against the S&P 500. The first column shows the GICS sector weightings for the S&P 500, with the subsequent five columns representing each of the respective funds' over- or underweighting of the sectors, relative to the benchmark (positive numbers represent overweight sectors and vice versa).

Sector Weightings Relative to S&P 500
	Portfolio % Weighting	+/- Sector Weightings Relative to S&P 500 Benchmark
Sector (GICS)	SPY	XLG	DGT	DIA	VIG	NY
Energy	13.03	3.72	8.64	(0.28)	(5.11)	5.88
Materials	3.38	(2.06)	(0.72)	0.15	2.36	(0.68)
Industrials	10.12	(2.65)	(6.09)	8.95	4.10	1.29
Consumer Discretionary	8.91	(4.47)	(6.54)	1.13	2.67	(3.58)
Consumer Staples	12.00	2.65	1.47	4.58	14.04	5.17
Health Care	13.92	(1.06)	0.75	(4.74)	(0.84)	2.28
Financials	13.52	(2.07)	(0.69)	(6.33)	(1.68)	(0.80)
Information Technology	17.79	6.79	0.04	(1.18)	(11.12)	(10.23)
Telecom Services	3.46	2.25	5.74	1.60	(3.43)	1.56
Utilities	3.88	(3.10)	(2.60)	(3.88)	1.00	0.90

Obviously, someone with a negative thesis on energy should probably steer clear of iShares NYSE 100 Index NY and SPDR Dow Jones Global Titans DGT, as those ETFs overweight the energy sector. Vanguard Dividend Appreciation ETF VIG might be a more suitable choice for such investors as it holds an underweight position in energy. However, we must also consider that VIG is making an implicit bet on consumer staples, while massively underweighting the tech sector. By the same token, analyzing the table shows that along with the energy sector, DGT is overweight telecom services, while being underweight in industrials and consumer discretionary.

To take our analysis one step further, we also evaluated various valuation metrics for these ETFs and how they compare with the broader market--as represented by the S&P 500. As shown in the table below, our five moaty ETFs tend to be cheaper than the market based on aggregate price/earnings and price/cash-flow ratios. Not only that, but the ETFs also--as a whole--tend to be composed of more-profitable firms with higher returns on equity and assets. Not bad at all.

Valuation Metrics
	Avg Mkt Cap ($M)	P/E Ratio (TTM)	P/C Ratio (TTM)	Net Margin % (trailing)	ROA % (TTM)	ROE % (TTM)
Rydex Russell Top 50 (XLG)	104,435	13.22	7.42	12.40	9.54	22.06
SPDR DJ Global Titans DGT	111,310	9.12	5.36	12.30	9.64	22.43
DIAMONDS Trust, Series 1 (DIA)	86,447	12.16	7.51	10.87	9.24	26.74
Vanguard Dividend App ETF (VIG)	30,360	11.44	7.85	11.35	10.37	26.84
iShares NYSE 100 Index	68,540	12.48	6.90	10.64	8.10	21.60
SPDRs (SPY)	36,596	13.38	7.26	9.55	7.23	18.57

To be sure, these are trying times for investors. On a dime, sentiment can shift from "green shoots" to Armageddon. But by making sure that our portfolios contain generous helpings of firms endowed with economic moats (that is, the ability to earn returns that are in excess of the cost of capital for a sustained period), we'll be prepared to weather the market's head winds comfortably. Remember: Moats matter. While it's difficult to say what our health-care or financial systems might look like in 10 or 20 years, we can say with a certain degree of confidence that folks will still likely be drinking  Coca-Cola (KO) and shopping at  Wal-Mart (WMT). Hence, own companies with durable competitive advantages that protect their ability to earn economic profits.

Note: The ELEMENTS Morningstar Wide Moat Focus ETN  was the top fund in the screen referenced in this analysis. Our screen eliminated all ETFs and ETNs that have more than 5% of assets invested in no-moat companies. WMW, which is composed solely of wide-moat stocks, provides zero exposure to no-moat companies. However, we excluded it from this article because ELEMENTS licenses the Wide Moat Focus Index from Morningstar, Inc., and Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.