Morningstar Magazine - August/September 2017 - 29

U.S. stocks with a wide moat rating regardless
of valuation, has trailed the Morningstar US
Market Index more often than not annually. Since
inception, it has earned an average annual
return of 8.7% versus 10.1% for the benchmark. The
Wide Moat Index has produced less volatility
over this period, but the difference isn't significant
enough to compensate for lower returns.
Sharpe and Sortino ratios for the Wide Moat Index
are roughly in line with those of the Morningstar
US Market Index. The Wide Moat Index provides
an apples-to-apples comparison to the Wide Moat
Focus Index, as all Wide Moat Focus Index
holdings are included in the Wide Moat Index.

The significant difference between their relative
long-term performance points to a core principle at
Morningstar: Valuation is critical. Wide-moat
stocks are often in favor when tumultuous market
periods drive capital toward stalwart high-quality
stocks. However, patiently buying quality
firms at attractive prices is key to long-term
investing success.
Security Selection Drives Alpha

Attribution analysis highlights stock selection as
the key driver of performance for the Wide
Moat Focus Index ( E X H I B I T 2 ). The allocation effect
accounted for a very small part of the total

active performance in most periods. The selection
effect was dominant, accounting for more than
98% of excess returns. In other words, rather than
relying on sector allocation to drive alpha, the
strategy did an excellent job of including the right
stocks within each sector.

Morningstar US Market Index benchmark
by 10 percentage points in 2016, and more than
70% of this outperformance was driven by
security selection.
The positive security selection effect in the
overweighted consumer cyclical sector offset the
negative allocation effect of not holding any
communication services or utilities stocks by more
than fivefold. Healthcare had the highest sector
weighting in 2016, making up nearly one
fourth of the index. Although healthcare stock
selection provided a modest headwind to overall
performance in 2016, the depressed valuations
of our healthcare holdings have led us to increase
our allocation to healthcare stocks in early
2017, patiently waiting for our investment theses
to play out.

The detailed sector analysis in EXHIB IT 3
demonstrates that the Wide Moat Focus Index
has historically favored the financials
sector and avoided the energy sector relative
to the Morningstar US Market Index. Simply put,
sector tilt is a byproduct of our economic
moat analysis and stock-picking, both bottomup processes, and does not rely on a
top-down overlay.
The Morningstar Sector Weighting category
reflects the allocation effect by sector. Both the
historical underweight in energy and
overweight in financial services have driven
a negative allocation effect. For the energy sector,
a positive selection effect has served as a very
slight offset. For the financials sector, however,
a negative allocation effect has been far
outweighed by a highly positive selection effect.

Risk-Return Characteristics

The Wide Moat Focus Index provided more
attractive risk-return characteristics than
its benchmark, the Morningstar US Market Index,
generating average annual returns of
14.6% since inception compared with 10.1% for
the benchmark.
The Wide Moat Focus Index faced increased
volatility relative to the benchmark, but the higher

Recent Performance

The Wide Moat Focus Index outperformed the

EXHIBIT 2

Dominant Stock-Picking According to an attribution analysis, stock selection has been the key driver of the Wide Moat Focus
Index's excess returns.
Allocation Eﬀect

Selection Eﬀect

Active Return
20
%
15
10
5
0
-5
-10

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: Morningstar Direct. All data 01/01/2005-12/31/2016. Benchmark: Morningstar US Market Index.

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Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017