What are we looking for
Canadian-domiciled ETFs that hold companies with competitive advantages.
The screen
Recent weeks have reminded investors how quickly the market narrative can shift. Escalating conflict in the Middle East has added another layer of uncertainty to global markets, and equities have responded with a modest pullback as investors reassess risk and potential economic spillovers. For Canadian investors, these shocks can feel amplified. The domestic equity market remains concentrated in a handful of sectors – most notably financials, energy and materials – many of which are directly tied to the macro forces driving today’s volatility.
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At the same time, investors are coming off a period where one traditional hedge delivered unusually strong results. Gold rallied sharply over the past year, supported by geopolitical risk, central-bank demand and persistent inflation concerns. Canadian portfolios felt this impact more directly than most given that gold equities were a meaningful contributor to domestic market returns. However, history suggests that such contributions tend to be episodic rather than persistent. The magnitude of the most recent rally may therefore be difficult to repeat. Hence, if volatility remains elevated and recent hedges have already delivered outsized gains, investors may need to look elsewhere for resilience.
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One place to start is with the durability of the underlying businesses held in a portfolio. Morningstar’s equity research framework centres on the concept of an “economic moat” – a company’s sustainable competitive advantages that allow it to fend off competitors and maintain pricing power over time. Morningstar’s framework points to five unique sources of economic moats: (1) Switching costs are those obstacles that keep customers from changing from one product to another; (2) The network effect occurs when the value of a good or service increases for both new and existing users as more people use that good or service; (3) Intangible assets are things such as patents, government licences and brand identity that keep competitors at bay; (4) A company with a cost advantage can produce goods or services at a lower cost, allowing them to undercut their competitors or achieve higher profitability; (5) Efficient scale benefits companies operating in a market that only supports one or a few competitors, limiting rivalry. Morningstar’s thesis is that companies with durable competitive advantages tend to generate returns on invested capital above their cost of capital across a full market cycle, helping them sustain profitability even as market conditions fluctuate.
With this in mind, I used Morningstar Direct to screen for Canadian-domiciled ETFs that:
- have received a four- or five-star Morningstar rating for funds (star rating), indicating historical outperformance versus peers on an after-fee, risk-adjusted basis. The rating incorporates up to 10 years of performance history, with greater weight placed on the most recent three years;
- OR: have earned a Morningstar Medalist Rating of Bronze, Silver or Gold, reflecting Morningstar’s forward-looking view that the fund has the ingredients to outperform peers on an after-fee basis. This assessment incorporates our evaluation of parent (stewardship quality), people (portfolio management experience) and process (the robustness and repeatability of the investment approach);
- hold at least 30 per cent of net portfolio assets in wide-moat companies, according to Morningstar’s equity research, indicating exposure to firms with durable competitive advantages and the potential to sustain excess returns over a full market cycle.
Only Canadian-listed ETFs were considered in today’s search.
What We Found
The accompanying table is organized by category and also displays management expense ratios, trailing returns, Morningstar ratings and distribution of moats across the portfolio. Readers will quickly notice that several qualifying ETFs follow a dividend or low-volatility mandate (evident in name) – a welcome result given we didn’t explicitly screen on this mandate. In cases where multiple versions of a single ETF were found (often in hedged/unhedged or U.S.-dollar versions), the hedged version is displayed given that the nature of today’s screen is to avoid volatility, which can be affected by currency fluctuations. Investors are urged to take note of the fact that not all qualifiers belong to a broad equity category, noting some sector-specific ETFs made today’s cut. For the conservative investor, sector-specific ETFs should typically make up a smaller part of a broader asset allocation to ensure diversification across the economy.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
This article is provided for informational purposes only and does not constitute financial advice. Investors should conduct their own independent research before buying or selling any of the investments listed.