A Forward-Looking Approach To Evaluating ETFs

When the world’s first exchange traded fund, the S&P 500 SPDR (SPY), was listed over a decade ago, things were simpler. People were broadly familiar with the S&P 500 index, and assuming an investor had already decided to try to track the index, explaining the advantages and disadvantages of the ETF structure versus that of a comparable index mutual fund was sufficient as far as ETF analysis was concerned.

Since then, however, the number of ETFs available to investors has exploded. The array of over 400 choices and the flexibility it brings is positive, but it also complicates the selection process. How do I know which ETFs make the most sense for my portfolio?

Perhaps because ETFs started out being compared to mutual funds, as they grew in number most analysts started evaluating them as mutual funds. Morningstar™, for example, the large mutual fund rating outfit, says in materials on its website, “The Morningstar Rating for exchange-traded funds uses the same methodology as the Morningstar Rating for [mutual] funds.”

Therein lies the problem. Mutual funds are typically evaluated based on past performance and fees. That's appropriate for most mutual funds, which are actively managed, because what you are really doing is hiring a manager to invest on your behalf. But with ETFs it's different. There is no active manager deciding when to buy or sell certain stocks; no one, for example, deciding when to lighten up on a certain sector or when to increase exposure to a certain market cap segment.

There is nothing inherently good or bad about a particular index that an ETF tracks. Rather, the investment merit of an ETF is determined by two factors: market conditions, and the fundamentals of the underlying stocks which comprise the fund. These, of course, change all the time.

This difference is like night and day; it is one being backwards-looking versus forward-looking. Who is not aware that, over the past five years, Technology stocks in general were a bad investment? What moderately-informed investor doesn’t already know that over the same time period small cap stocks outpaced large cap stocks? If a mutual fund manager failed to foresee changes in the economy and in the market, and stayed overexposed to large cap Tech stocks, you’d have a valid complaint that he was probably not earning his keep. But an ETF tracking an index of Tech stocks, or an index of large cap stocks, didn’t change its portfolio because it isn’t supposed to—it is just supposed to track the index.

However, concluding that, based on past performance a Technology ETF is therefore a bad investment going forward, or that a small-cap ETF is therefore a good investment, is absurd. It tells you next to nothing about how they are likely to perform in the future. And besides, unlike a mutual fund you can short an ETF, so even a bad investment, correctly identified, can be turned into a good thing.

So how do we intend to divine any forward-looking measurements of an ETF’s investment merit? Our firm has a set of existing tools that can help. One of the least-recognized but most important advantages of an ETF is their transparency. As a result it is possible to marry the list of constituents with all the fundamental data available about those constituents to create a very informative picture of the basket as a whole.

One can find the answer to important questions such as:

• Which ETFs offer the best earnings growth? The best dividend yields?
• Which are seeing estimates raised, and where are they getting slashed?
• Which show trouble brewing on the balance sheet?
• How is it valued, relative to expectations and relative to other ETFs?

You can use this information either to compare ETFs across categories or within categories. For example, two popular options for tracking small cap stocks are the iShares S&P Small Cap 600 index fund (IJR) and the iShares Russell 2000 index fund (IWM). Both are from ETF-giant Barclays, both have an expense ratio of 20 basis points, and both have three-star ratings from Morningstar™.

So now what? If I told you that one of those indexes was trading at 18.1x estimated earnings per share this year, and the other was trading at 23.2x, wouldn’t that knowledge perhaps make a difference?

If you were concerned about a slowing economy and wanted to position your portfolio for the next downturn and I could tell you that during the last recession profit margins for both indices declined but that for one of them profit margins declined much worse—and in fact were negative—wouldn’t that information affect your investment planning?

To be sure, there is no guarantee that current expectations about fundamentals will prove to be accurate—or even if they are that the market will care in the near term. But over the long term, most investors believe that fundamentals such as earnings and valuations are what drive the stock market. That is why before buying stock in, say, General Electric—which after all is really a collection of business not entirely different from an ETF— most people would make an effort to compare GE’s fundamentals to that of other industrial companies, and to the market in general.

And this is why I employ a fundamentally different approach to ETFs in my advice to clients, an approach that is rooted in fundamentals. This approach is intuitive, forward-looking, and, I believe, a lot more relevant than past performance.

Comments

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Mr. Krause begins the article with a frequently parroted mistake. SPDRs was NOT the World's first Exchange-Traded Fund -- nor even North America's first exchange-traded fund. THat honor is held by the TIPS (Toronto Index Participation Shares), representing the Toronto Stock Exchange 35 Index, that started trading in November 1991. The first US ETF preceded SPDRs to markets by three months; this was the Leland-Obrien_rubenste... launched SuperShares which was also based upon the S&P 500 Index, but was more complicated than the SPDRs.

2007 Mar 26 09:58 AM