Morningstar Doesn't Get What ETF Investing Is All About

Morningstar does interesting research on many things, but they don't get ETFs at all.

That point was hammered home Tuesday when Morningstar published its list of "The Worst ETFs of 2007." That's a fun topic. With more than 200 ETFs launched last year, there are more than a few you could pick on.

But the ones Morningstar chooses make no sense at all. In fact, they showcase all the reasons why Morningstar gets ETFs wrong.

Take the very first funds on Morningstar's list: the SPDR S&P China ETF (GXC) and the First Trust ISE ChIndia ETF (FNI). "These markets have been smoking in recent years," writes Jeffrey Ptak of Morningstar. "Not surprisingly, they look rich to our eyes."

That may be true, but it's not the point. ETFs are best used in long-term asset allocation strategies, not for chasing hot trends. The way to evaluate ETFs is to choose the best one within each asset category, not to try to game the market by choosing the "right" asset categories.

In this case, the SPDR S&P China ETF (GXC) was actually one of the best ETFs launched last year. Compared with other China ETFs, such as the popular iShares FTSE/Xinhua 25 ETF (FXI), GXC offers a more diversified portfolio and broader exposure to the Chinese market. For starters, it has 150 components compared with FXI's 25. FXI also has more than 25% of its portfolio in its three largest names, while GXC takes a more diversified approach to the market. The third China ETF—the PowerShares Golden Dragon Halter USX China ETF (PGJ)—is too strongly underweight the Financials sector for my liking.

For investors looking to add China to their portfolios, GXC may actually be the best choice.

Will China go up or down in 2008? I have no idea. But that doesn't make GXC a "bad" ETF, any more than the S&P 500 falling next year would make SPY a "bad" ETF.

It is the same basic flaw that dooms the Morningstar STAR rating system: a focus on short-term performance rather than long-term, sound portfolio construction. That may work for active funds (although the data suggest otherwise), but it certainly doesn't work for ETFs.

Written by Matthew Hougan

Comments

[Indexor:]

Matt, I couldn't agree with you more. Unfortunately, you and I both know that Morningstar has a staff of very bright, investment-wise individuals who understand the markets. But Morningstar has a vested interest in mutual funds, not ETFs. They have carefully and craftily written negative articles over the past few years, likely to appease their main business partners - the traditional open-end mutual fund companies.
Their stance on ETFs is simply too transparent for anyone who has been in the investment business for more than ten years to take seriously. They must not care very much about the increasing damage they are doing to their reputation as more sophisticated investment people eschew their star system for actively managed open-end funds in favor of a more intelligent choice.
Had Morningstar embraced ETFs, their reputation as an unbiased and trustworthy provider of investment research would have grown considerably. But there actions over the past few years have left them with very little value other than being another statistical data provider of past returns. And the ETF providers already provide that service themselves.

2008 Jan 10 01:33 PM

[goalposts:]

Glad to see you write this article, Matthew; someone has been needing to say this about Morningstar. They are buried in an old, traditional style of investing and don't take well to new ideas.

2008 Jan 10 06:59 PM

[d_teller:]

i enjoy reading your frequent commentary. I commend you on your remarks about M* inadequacies. Unfortunately, my brokerage continues to rely on M* for its stock and fund ratings and tax info for 1099's. The misinformation on the 1099's is appalling. The lack of real research by M* into TIAA-CREF's special "life-time" expectancies and payouts; CREF's long and short subperformance vs benchmark indices, and the lack of correct information on qualified dividends from ADR's, to cite a few areas of poor analysis by M*, is just awful. M* doesn't have a handle on CEF's, and it doesn't have a sense of its own limitations.

2008 Jan 10 09:48 PM