Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into account your personal situation, circumstances or needs. 

Mark Lamonica: Well, Shani, I wouldn't call it the world most exciting night, but we hung out last.

Jayamanne: We did, yeah.

Lamonica: We went out to dinner. And I tried to order a salad and it was ordering off of those apps, that new app on your phone. And so, you took my phone and changed my order from salad to steak.

Jayamanne: Yeah.

Lamonica: Which is interesting because you keep telling me I'm old and I'm about to die and now, you won't let me eat anything healthy.

Jayamanne: So, you might as well enjoy it, you know.

Lamonica: Yeah. So, we had that happen. And then, the other thing is, you made me watch the 1996 World Cup where Sri Lanka beat Australia. But I think the best part about that 1996 World Cup final was the uniforms…

Jayamanne: The were very retro.

Lamonica: …and how ridiculous the uniforms were. Well, they weren't retro at the time. They were just…

Jayamanne: They were just uniforms.

Lamonica: They were just uniforms. But anyway. My cricket education is growing.

Jayamanne: It is.

Lamonica: Shani said that when she gets members at the SCG, she's going to take me to cricket matches…

Jayamanne: Yes.

Lamonica: …and teach me more about cricket.

Jayamanne: I've been on the wait list now for four years.

Lamonica: Don't you have like 10 to go?

Jayamanne: Yeah. The average is 12 years waiting. So, I've got 8 to go.

Lamonica: Alright. Well, I definitely won't be alive for that. So, you can take someone else. But why don't we get…

Jayamanne: Hopefully, we have a good cricket team. By we, I mean, Sri Lanka by that. I'm sorry.

Lamonica: Okay. Well, we'll see what happens. Maybe I should bring back those uniforms.

Jayamanne: Yeah.

Lamonica: We're going to talk about investing in quality companies today. And specifically, we're going to look at a couple of ETFs that are designed to give investors exposure to these quality companies.

Jayamanne: So, Mark, would you say these ETFs are quality thematic ETFs, because I seem to remember numerous discussions about how investors should avoid thematic ETFs?

Lamonica: Discussions is a nice way of putting it because you always used to describe it as rants. But okay. There is no standard definition for what a thematic ETF actually is. So, I'm going to go with the Mark Lamonica definition. And more than getting caught up in the semantics of what we've been calling these things, I think we should talk about what we believe investors should be looking for when evaluating investment opportunities. So, let's start with, I guess, what investors should avoid in our opinion. So, the issue with many of these thematic ETFs is that they are marketing inventions, which means that well after we've seen strong returns on certain shares, they create an ETF, and this ETF is also created to take advantage of a widely accepted theme. So, there are generally two things associated with that ETF that make it likely over the long term you will not experience strong returns. So, Shani, since you've listened to all these rants, what are those two things?

Jayamanne: All right. So, the first is that the already strong returns means valuation levels are typically really high given all the hype. And we know that in general, shares with really high valuation levels have lower long-term returns than shares with low valuation levels. And the second is that thematic ETFs generally have higher fees than non-thematic ETFs, and higher fees of course detract from investor returns.

Lamonica: Yeah. And the other thing about thematic ETFs is that they encourage poor investor behavior. So, this notion that investors should always be looking for the latest themes and should always look for these new opportunities as represented by these new ETFs of course means that investors are trading more.

Jayamanne: And we should be clear that the more you trade, the more you switch products, the more you chase returns, the lower your long-term returns will be.

Lamonica: Yes. So, that is why I think thematic ETFs are terrible. Now, when we look at a factor ETF, so an ETF that has shares with higher dividend yields or what we're going to talk about today, ETFs that have quality companies, it's a whole different ball game. So, on Investing Compass, we're huge advocates for investors to design portfolios around the goals they want to achieve, around their age or the competitive advantage that everyone has it as an investor and around the types of securities that people are comfortable holding.

Jayamanne: And that alignment with goals, competitive advantages, and the comfort level and temperament of an investor means that you're more likely to hold these positions for longer and avoid all that short-term trading behavior that's so detrimental to long-term returns, and those are all positives.

Lamonica: They are, Shani. So, let's move on to the topic for today. We are looking at quality ETFs. But before we do that, we want – and before we get into those specific names that we'll explore today, we want to talk about quality in general and what we mean by that for investors.

Jayamanne: All right. So, quality investing is a fundamental investment strategy that looks for characteristics that denote high-quality companies, and these can be both qualitative assessments where a human assesses and decides that a company is high-quality and more quantitative factors based on metrics like levels of debt, and we will obviously dive into these specific metrics a little bit more.

Lamonica: Yes. And the other important question, of course, is why anyone would want to invest in quality companies in the first place. So, what is the benefit to investor for finding these quality companies? Well, the first is downside protection. High-quality companies are less likely to go out of business, which for an investor in shares is obviously the worst thing that can happen because you generally lose all your money.

Jayamanne: Now, in a practical sense, that means that you're going to get less volatility even if those companies don't go out of business. So, in times when the market gets nervous about risks and those riskier low-quality companies fall, the quality companies fall less.

Lamonica: And there's something that you exchange for that. Quality companies fall less during downturns than they often conversely rise less during euphoric times when investors are clamoring for more risk and seeking it out, and that is, of course, what lower volatility means.

Jayamanne: The other thing about quality companies is that the advantages that they have over other companies, whether that's better management or competitive advantages against their rivals, tends to play out over the long term, and the combination of these two things means that a quality investing strategy is a long-term strategy. This is not something that you should be trading into and out of. Let those quality attributes accrue to you over the long term, which of course is what we think you should do anyway as an investor.

Lamonica: I think we painted a bit of a picture here about quality, but let's dive into these ETFs that we're going to explore today because I think that will hopefully bring this story to life. Now, we're going to look at two different ETFs today, and they're both VanEck products. We are looking at the VanEck Morningstar Wide Moat ETF, with the ticker symbol MOAT and the VanEck MSCI International Quality ETF with the ticker symbol QUAL.

Jayamanne: Now, before we get into the details here, we want to give an important disclaimer. We're not advocating that anyone purchases these ETFs; they're representative of a strategy that we are exploring today.

Lamonica: And I will admit that this is a strategy that aligns with my view of investing, but investing is very specific to each of us, and the strategy that I feel is right for me does not mean everyone or anyone should follow it.

Jayamanne: The second important thing is that you may have noticed that the MOAT ETF we're looking at has Morningstar in the name. This is not a Morningstar product and it's issued by VanEck. But Vanek pays Morningstar to use a Morningstar index for that product. So, we make money off of that, just like a company tracking the S&P 500, they pay Standard & Poor's or S&P for using that index. And because VanEck pays Morningstar for this product, our analysts don't rate it because we think it's a conflict of interest.

Lamonica: So, there we have it. Let's dive into these ETFs. So, in both cases, these ETFs are attempting to identify quality companies. So, let's start with MOAT. Now, Shani mentioned MOAT follows a Morningstar index, and that index is called the Morningstar Wide Moat Focus Index. This index is an equal-weighted index which listeners should know means that an equal amount is allocated to each share in the index. The index also uses inputs from our equity research team. Those inputs are companies that have wide moats as determined by our analysts and companies that our analysts believe are trading at attractive valuations. The last key to the index is that it is a vehicle to invest in U.S. companies.

Jayamanne: And let's take a look at the portfolio here. There are a couple of things that jump out. To be included a company needs to have a wide moat rating by our analysts and be considered cheap. And while that analyst research is done by people, the formula to pick the securities to go into the index is rule-based. And twice a year in June and December the index is reconstituted, which basically means that all the securities are re-ranked by their fair value and a couple of rules are applied to ensure that the sector weightings match the overall market, and then you'll have the index for the next six months.

Lamonica: So, let's explain a couple things here. The first is this sector waiting rule. The rule is meant to ensure that the wide moat portfolio is basically representative of the overall sector weightings in the market. So, if the overall U.S. market has 30% allocated to technology, you aren't going to suddenly get a moat index that is 90% allocated technology. It will stay in a relatively narrow band around that overall allocation.

Jayamanne: The second important thing for investors to know is that since the ETF follows the index and is equal weighted and the index changes every six months, it means that the ETF will rebalance and buy or sell securities that enter into and fall out of the index.

Lamonica: And that has consequences for investors. Those are taxable events and capital gains for appreciated securities will be passed on to investors. In other words, they are distributed to you, and you will have to pay taxes on those transactions.

Jayamanne: The last thing we need to mention is that this is a concentrated portfolio. It currently has 48 holdings, and of course, we're trying to look for high-quality companies so this makes sense.

Lamonica: You do have to have standards, Shani.

Jayamanne: Yeah, exactly, Mark.

Lamonica: Okay. Now, we aren't going to go too much into the portfolio, because frankly, our analysts clearly like all the names and because it's equal weighted and rebalanced every six months, there isn't really a huge allocation to any one security. But we do want to look at how this ETF has responded to different market conditions.

Jayamanne: Now, the ETF has been around since June of 2015, but the index has been around for a lot longer. But if we look at the ETF, it has returned 13.55% a year. Now that compares to an S&P 500 return of 11.75% a year. If we look at shorter time periods, we can see that it hasn't performed as well in the last three years, for example. In that time period, it returned 9.05% per annum versus 9.5% for the S&P 500.

Lamonica: And part of this period was obviously the big run-up post COVID, but part of it was also the poor year that we've seen in 2022. So, year-to-date, we've seen a return on the ETF of negative 10.87%, and that compares to fall in the S&P 500 of just about 15%. Now, these returns are both in Aussie dollars, so they benefited from the fall in the Aussie dollar.

Jayamanne: So, we have seen some downside protection in a rough market, at least in this instance it worked. There are a couple of other attributes we should look at. The volatility in the portfolio has been pretty close to the market over the last five years looking at two different measures – beta and standard deviation. We've talked about these two measures before, and we aren't going to spend a lot of time on them because they're only slightly below the overall market, but the price has bounced around just about what it would have if you invested in the index.

Lamonica: There are two other important considerations. The first is that if you're looking for income, this isn't really the place for you. The dividend yield of the holdings is 1.98% versus the overall index of 2%. So, this methodology is not identifying companies that pay out higher dividends.

Jayamanne: The last consideration is a fee that you're paying. It is certainly higher than an index tracking product. The fee is 0.49%, and that compares to an S&P 500 index product like IVV, which has a fee of 0.04%.

Lamonica: And finally, we want to talk about portfolio turnover. As we've said, this thing is getting rebalanced, and the securities are potentially changing every six months, and the turnover rate is 49%. That basically means that over the past year, 49% of the holdings are new. So, given that it has 48 holdings, it means 24 of them are new.

Jayamanne: Why don't we shift gear to the other ETF that we're looking at? And this is the other VanEck ETF with the ticker symbol QUAL. Now, the MOAT ETF was using qualitative assessments of quality as defined by our analysts and was placing a valuation overlay on that quality. This next ETF is just looking at quantitative metrics to identify quality companies. So, what are those, Mark?

Lamonica: Well, it is tracking index that looks at three different things to identify quality companies. It's looking for companies with attractive returns on equity, stable earnings growth and low financial leverage. So, we'll walk through each one of those. So, Shani, start us out with return on equity.

Jayamanne: Return on equity is a measure that is calculated by dividing net income by shareholders equity or book value. It's intended to show how efficiently a company generates profits, the thought being that the higher the return on equity, the better the company is at generating profits off of assets. And that, of course, is a good thing, a bit like the return on invested capital that we always talk about and associate with moats.

Lamonica: So, the next measure is stable earnings growth. Well, I've never been called stable. It's something you're going to look for with earnings growth, right Shani? Okay. She thought that one was pretty funny. So, what we're trying to do is identify companies who have steady and consistent growth in earnings. This is going to eliminate companies that are extremely cyclical, which means that their earnings vary depending upon where we are in the economic cycle, and it will eliminate companies that are price takers, like a lot of commodity companies.

Jayamanne: And finally, they're looking at companies that have low debt, which, as we said earlier, makes companies less risky. And these three factors are combined, and a quality score is given to each company in the overall index and the top ones are included in the quality index and the ETF.

Lamonica: And in this case, we're looking at a global index that just excludes Australia. And there are no limits on countries and no limits on sectors, but there is a 5% limit put on the size of any single holding. This product is not equal weighted, and the weights are based on market cap.

Jayamanne: The MOAT ETF was very concentrated, but QUAL is not. It has 300 holdings in it. It's also rebalanced semiannually. So, because it has a wider remit of 22 developed market countries, it's market cap weighted and has no sector or country limit on allocations. We can spend some more time looking at the portfolio.

Lamonica: So, we'll start at the country level. 77% of the holdings are in the U.S. Now, that is higher than the overall allocation to the U.S. in a global developed market index, but not by a ton as U.S. represents around 70% of the index without that quality lens. The next highest holding is Switzerland with just under 6% and then Japan at 3.73%.

Jayamanne: If we look at sectors, it is very overweight technology and healthcare. It's very underweight basic materials, energy, consumer cyclical and financial service. And that makes sense because it is screening for companies where the earnings bounce around less. Basic materials, energy, consumer cyclical and financial services are all sectors where you tend to get a bit more of a rollercoaster in earnings as we move through economic cycles, and because energy and basic materials rely on volatile commodity prices.

Lamonica: There's also a fair amount of concentration in the top 10 holdings, with 31% of the 300-company index in those 10 holding. The largest holding is Apple, which is followed by Microsoft, Johnson & Johnson, United Healthcare and Alphabet, which is Google's holding company. All names that you'll find at the top of most of the developed market or U.S. indexes that are market cap based.

Jayamanne: Now, the Morningstar moat rating is of course not something that goes into the selection criteria, but it obviously is synonymous with quality. So, you would expect to see some overlap. In this case, you certainly do as over 90% of the holdings have a wide or narrow moat rating with 64% receiving a wide moat rating. That compares to only 38% of the overall index.

Lamonica: And the moat rating makes more sense when we look at stats like return on invested capital, where the portfolio comes in at 26.47% versus 17.56% for the overall index. So, I do think that this does check the quality box and it is what it says it is.

Jayamanne: And if we go back and look at performance to when the ETF was first issued in October of 2014, we see that it has outperformed the overall MSCI World ex Australia Index. Since inception, it has an annual return of 13.17% versus the index which came in at 10.92%. However, we haven't really seen the downside protection this year, as it has fallen just over 20% year-to-date with the overall index down 15.81%.

Lamonica: And a lot of that poor performance this year can be attributed to the fund being so overweight technology shares which have had a terrible year. Now, year-to-date is a very short timeframe to be looking at performance, but we did want to include it because that is one of the attributes that many people talk about with quality that you have this downside protection when things are going wrong.

Jayamanne: The portfolio turns over less than the MOAT product we explored earlier with 24%, which means that you're getting just about a quarter of the portfolio being replaced every year. We also see the fee is lower at 0.4% per year versus 0.48% for MOAT. That is, once again, well below what an actively managed ETF would charge you but way higher than just a pure index ETF.

Lamonica: And then, finally, if you look at income, we can see that this portfolio yields just under 2%, which is similar to MOAT. But in this case, we see the overall index as higher yield at 2.77%. We're certainly not getting much income from it.

Jayamanne: Since there isn't a conflict of interest with this ETF, it is rated by our analysts. They give it a Silver medalist rating, which is our second highest rating. Our analysts say about the ETF that it's for investors seeking exposure to high-quality global equities at a low fee, VanEck MSCI International Quality, QUAL, is a strong choice. We continue to have high conviction on the strategy's ability to deliver outperformance over the peer group median and serve investors well over the long term.

So, those are two quality ETFs, and there are countless others as well. For instance, while MOAT concentrates on U.S. shares, there's a global share Morningstar wide moat product with the ticker symbol GOAT and an Aussie one as well with the ticker symbol DVDY. BetaShares also has a quality-oriented ETF available as does State Street and iShares by BlackRock.

Lamonica: So, what is GOAT? What does the ticker symbol GOAT make you think of now?

Jayamanne: Greatest of all time.

Lamonica: Oh, okay. Well, I was thinking about Lisa. Lisa, the Morningstar superfan, rescued a goat. So, it was raining, and the goat had gotten separates a baby goat, a kid…

Jayamanne: Yeah.

Lamonica: …I believe they called them. And Lisa found this goat and rescued it. And then, the farmer that she rescued it for named the goat Lisa. So, she has a goat named after her.

Jayamanne: I think you've told this story already.

Lamonica: Have I?

Jayamanne: Yes.

Lamonica: I think this must be my favorite then. I thought I told it on a webinar.

Jayamanne: No, I think you did that also.

Lamonica: Okay, wow. Well, anyway, I apologize for that. Anyway, I'll try to come up with another story. But as Shani said, there are multiple different options out there for quality ETFs. And because there's so many choices, we would encourage you to go through a similar review that we just did to understand how they are determining quality and the ramifications that definition has on the holdings and portfolio construction.

Jayamanne: The last step is thinking about how investors would use this in a portfolio. The first thing we would say is that it's really important to ensure that quality aligns with your investment strategy, which means that you take your goals, competitive advantage as an investor and your temperament into account. As we said, a quality strategy should be a long-term strategy.

Lamonica: And we would caution investors from taking the grab bag approach to building a portfolio of ETFs, and that's just adding a bunch of different ETFs that all sound good in isolation but create a bit of a hodgepodge of portfolio when mixed together. We can certainly see the investor following the individual logic and selling points on a quality ETF, but then doing something like buying the NASDAQ Tracking ETF to get exposure to technology and then maybe just an S&P 500 ETF since you want exposure to the U.S. Then, since you are Australian, you might own a couple of mining shares or banks or simply overweight basic materials, financial services and energy because you're overweight Australia even through an ASX 200 Index ETF.

Jayamanne: And if you add that whole thing up, you've got a quality ETF that is overweight technology mixed with the NASDAQ 100 ETF that's also overweight technology but includes low-quality tech names, and then, even though that part of your portfolio is underweight financial services, basic materials and energy, you throw in the Aussie components that cancel that out.

Lamonica: Yeah. And all of a sudden, you're faced with something that looks a lot like the overall index, but you were paying a lot more for it than simply using the ETF that tracks the MSCI Global Developed Market Index. So, just be careful with portfolio construction here. That obviously depends upon your allocations to each, but use a tool like portfolio X-Ray to see where your portfolio ends up and compare that to the overall index to see if you've created something that is at all different. You're going for a quality strategy because it's right for you, then I would say you should go for a quality strategy. Don't water it down. Just make sure that's the approach you're taking.

All right. We did it, Shani. I told a story twice, which was exciting three times.

Jayamanne: Three times maybe.

Lamonica: Three times? Okay. So, I think that's a sign of senility, right? So, you must be quite pleased. But anyway, thank you all very much for listening. We would love any comments you have in your podcast app or ratings, and of course, you can always email me. My email address is the podcast notes.