Morningstar's ETF Ratings -- What's the Use?

Includes: MORN, PWC, RSP
by: Richard Kang

I have a copy of Morningstar’s (NASDAQ:MORN) “ETFs 100” on my desk as it’s a decent source of info on US domiciled ETFs. It basically has a nice 1-page fact sheet for each ETF as of December 31, 2005. Each page has (thankfully) no assessment for the ETF in terms of number of stars although there is some commentary/opinions given in a few short paragraphs.

Yesterday I came across this from the website (sub. req.):

Is Simple Better?

Morningstar bestowed its highest possible mutual fund honor on the Rydex S&P Equal Weight ETF (NYSEARCA:RSP), awarding it five stars for the three years ending June 30, 2006. The Morningstar rankings are based on risk-adjusted performance, with funds measured against other funds in the same category – large cap growth funds against large cap growth funds, small cap value against small cap value, etc. RSP was evaluated in the “large blend” category, and apparently, it compared well.

Before we celebrate (and evaluate) RSP’s performance, however, let’s take a moment to pity the poor active fund managers in RSP's category. Imagine their fate: They've been staying up late, pouring over company filings; they've logged 100,000 air miles shuttling to and from conferences and corporate headquarters; their hair is turning gray, there are bags under their eyes, and they haven't seen the sun in weeks. Maybe they are doing well ... maybe their performance is up, and they're looking at three or even four stars ... when along comes RSP, flouncing by with its simple equal-weighting methodology, and it earns five stars without breaking a sweat. It is the idiot savant of strong performance. If I were an active fund manager, it'd drive me crazy.

I mean, let’s be serious: The strategy winning these accolades could not be simpler – you hold all the stocks in the S&P 500 at equal (0.20 percent) weightings, and rebalance quarterly. That’s it. No comparative analyses or complicated quant-driven programming. Instead, it’s like a kid in a candy store: I’ll take one of those, and one of those, and one of those…

I don’t mean to criticize the fund. RSP has delivered 16.27 percent annualized returns to shareholders over the past three years, compared to just 11.22 percent for the traditional S&P 500. And there’s a good body of evidence that suggests that both mid/small tilts and regular rebalancings are associated with improved performance – both of which RSP provides in one fairly inexpensive packet.

But the utility of the rating – like the utility of all Morningstar ETF ratings – is suspect. We know that RSP's portfolio sits on the very edge between mid- and large cap exposure (57 percent large cap vs. 43 percent mid-cap exposure, according to Morningstar). With that in mind, the rating tells us … what, exactly? That small/mid caps have outperformed large caps over the past few years? Well, yeah…

And if small/mid caps fall out of favor for a while???

I do think there is some utility in the Morningstar ratings for ETFs when applied to the fancy, quantitative strategies, of the kind introduced by PowerShares and its various followers. After all, those funds are trying specifically to “beat the market,” not to simply provide exposure to a given slice of the market. (Note: The PowerShares Dynamic Portfolio (NYSEARCA:PWC) – one of PowerShares' flagship “enhanced index ETFs” - has also received a five star rating from Morningstar, and has outperformed RSP over the past three years.)

But for most ETFs, I’m not convinced. So, congrats to RSP – they have an interesting fund that incorporates some basic good ideas for shareholders, such as rebalancing on a regular basis, and they’ve delivered strong returns. But my advice? Don'’t let it go to your head.

So, we now have Morningstar providing ratings for ETFs. Intuitively, I wouldn’t think that those in the investing world would find much value in Morningstar ETF ratings. Certainly, for the truly passive ETF based on the traditional, market cap weighted indexation, what would be the point? I suppose it would be similar to the S&P SPIVA reports which determine how well active managers beat their relative index. In the case of the Morningstar report, instead of comparing active managers within a certain asset class or subclass, they’d be making the comparison to the more appropriate, after fees/costs equivalent, ETF.

More importantly, the writer discusses the value of ratings on enhanced index ETFs with specific mention of PowerShares’ ETFs based on their Intellidex methodology. I would agree that Morningstar has a case to provide ratings to the new batch of ETFs based on quasi-active management. In addition to the ETF mentioned, this would also include those from PowerShares (based on RAFI methodology) and WisdomTree. Although DFA is not in the ETF space, it would be interesting to see Morningstar’s commentary on the fundamental indexation based ETFs versus the Fama-French based mutual funds from DFA. However, I’d be quite doubtful if their examination would be anything close to the highly quantitative analysis I’ve seen (William Bernstein, Burton Malkiel) seen recently surrounding the introduction of fundamental indexation funds from PowerShares and WisdomTree.

For me, as someone whose company tilts more against the role of manager selection, I have never been a fan of Morningstar ratings. I will only expand briefly on this by saying that if an investor can use some form of inexpensive means to gain broad market exposure (index derivatives or ETFs), that should be the focus. Manager selection should be limited to areas where these products just don’t make sense for various logical or logistical reasons such as private equity, hedge funds, infrastructure, etc.

Despite this, I suppose there’s nothing wrong with someone out there who has built a name - some would say good, some would disagree - based on rating funds (OEF or otherwise). What I don’t understand is how an investor can consider the Morningstar rating system anything more than a rough guide. Certainly I hope it isn’t used even partially to build an investment process.

Last thought: There’s been a lot of commentary online about the fundamental indexation ETFs. There has also been some analysis and follow-up commentary comparing FI methodologies and results to the Fama-French models. There has not been much discussion comparing any of this to RSP. Similar results in terms of dialing down the large cap in favor of small cap. RSP also has a longer track record, albeit entirely in a strong bull market. Morningstar ratings aside, the concept of equal cap weighting is so simple, it’s silly. Other indexes also have ETFs with equal weights. Of course they have their downside of greater trading costs and the related performance drags such as taxation. I’d be interested to know if the performance of equal cap weighting is inferior to fundamental indexation (whoevers version you use) for, let’s say the broad US equity market. Also, if so, by roughly how much?