ETF Analysis: Bottom-Up vs. Forward Looking

Roger Nusbaum submits: Morningstar ETF writer Sonya Morris has an article up called "How To Evaluate New ETFs" that I found via ETF Trends that, like most of what I have ever read by her, takes the wrong approach to ETF selection.

It seems that Morningstar tries to apply bottom-up analysis to ETFs, and I don't think this makes any sense.

Anyone constructing a portfolio using ETFs (or other types of funds) is specifically not picking stocks. They are either making decisions about the broad market, cap size, style, sector, countries -- or some combination of the above -- which I think are more forward looking than bottom up analysis (which looks at whether a stock is reasonably valued or not, and then assuming that if it is fairly valued, it will do well). This makes a lot more sense for a stock than for something like mid-cap growth. In her article she picks on some of the new emerging market ETFs from StateStreet because...

... Emerging-markets funds have notched double-digit returns for several years now, and it's hard to see them continuing at the same breakneck pace. Plus, the strong rally has pushed emerging-markets valuations to pricey levels, according to Morningstar's international stock analysts. It wouldn't be surprising to see that market segment cool, which would clearly be an unfavorable development for the new ETFs.

So is she saying investors should have zero in emerging markets? The article never clarifies so we can't know. Emerging markets is a segment of the market. Anyone interested in a diversified portfolio should always have some exposure. At any point in time there should be more or less exposure based on some of the things she mentions, but to be clear, she should be using those points as reasons for adjusting how much -- not deciding if.

She specifically questions the timing of SPDR S&P Emerging Markets (GMM) for the reasons stated above. This is the wrong way to look at it. The big point of differentiation with GMM is the lack of South Korea. This will make GMM more attractive more attractive for some people over something like iShares Emerging Market EEM, which is heaviest in South Korea.

I think the process needs to be more like "Do you want to be heavy or light in emerging markets?" Then, based on various big-picture things important to you, "What parts of emerging markets do you think are best -- commodity based, frontier, manufacturing based?" and so on. Once that is decided, "What is the best way for you to access emerging -- broad-based, narrow-based (which includes individual stocks) or some combination of both?" Then finally the individual picks.

If you want broad-based, but don't want South Korea, then GMM becomes your only choice making the analysis in the article moot.

Another misguided bit of insight is the poo-poohing of the PowerShares DWA Technical Leaders Fund (PDP). Ms. Morris notes that "PDP doesn't look compelling right now from a valuation perspective." She further goes on to note that PDP "smacks of performance chasing, and it completely ignores valuation, which is a core tenet of my investment philosophy. A look at this ETF's price characteristics confirms that valuation is not paramount here."

Are you kidding me?

I have not studied PDP, but I am thinking that a fund called Technical Leaders probably employs some sort of technical analysis as opposed to the bottoms-up that Morningstar believes in. Further we might glean that PDP does exactly what she says: chases performance and ignores valuation. On some level, isn't that exactly what technical analysis is? PDP may or not be a good fund, but she is essentially saying "I don't like technical analysis because I don't like technical analysis."

I continue to hold out hope that Morningstar can actually deliver useful ETF content. For now, not yet.

Comments

[mitsuo]

Generally, I find that Morningstar not a great fan of ETFs. I guess being biased against ETFs in the author's position is understandable, given that her company would become irrelevant if ETFs overtake mutual funds as the choice of investors and their money.

However, her stance is a bit perplexing, given the number of iShares products based on Morningstar indices and the free revenue flow that those funds provide to Morningstar. Perhaps that's why the author and her company usually focus on State Street's products?

Also, I found it most interesting that the author would bring an iPath into the article. These are structured notes, not funds. Is she comparing asset classes, returns, or structures?

[JonD]

Roger, your criticism is misguided and a bit hypocritical (if i may be so bold). the first and third major sections of the article sound exactly like something you would write --- a logical and fact-based dissection/comparison of different ETFs in a given asset class. and the section you focus your criticism on, ironically, also could have come from your pen/keyboard as you often explicitly (or implicitly) offer market timing suggestions for certain subsectors of the asset universe all the time.

i read most of the current ETF articles and this one is well above average relative to the incessant drivel of articles warning of "thinly sliced ETFs dangerous to your investing health."

[mitsuo]

What the heck are you writing about? Which most current articles? What does "well above average" mean?

[JonD]

ummmm.. i guess i'm talking about all of the articles on this web site plus lots of articles in various newspapers and other web sites. it's hard to be specific b/c there's so many published every day. i will direct you to a dictionary to understand what "well above average" means.

[RogerNusbaum]

JonD, I think the big picture idea that I am trying to convey is that trying to apply bottom up stock picking methods to ETFs is not very useful.

Further as far as timing, I believe I am very consistent in saying that I am increasing or decreasing and I preach on and on about never being zero weight in something as big as emerging markets. Her implication is to have zero in emerging markets right now (this is simply what I think I'm reading).

It might be my inability to explain this well but I'm <em>telling you</em> that her article is very different and I think of no value.