Fundamental Research on ETFs

by: Buyside Research

Stock analysis begins with time-tested fundamentals to measure growth, profitability, capitalization and valuation. These fundamentals are essential to evaluate companies. The same should be true of ETFs. A systematized process can apply the same fundamental measures to compare and value equity ETFs. As is the case with stocks, the process reveals that ETFs with superior fundamentals perform better than ETFs with inferior fundamentals.

So that investors can compare funds, two important database adjustments are part of the methodology: (1) fiscal periods have been realigned so that data cover the same time period (for example 2004 earnings); and (2) negative numbers are included in portfolio aggregates. This methodology makes our results more reliable than comparable numbers calculated by others. Moreover, without applying this methodology, accurate fund comparisons cannot be made.

ETFs invested in stocks with good fundamentals outperform

P/Es are simple, essential metrics of stock analysis. Earnings growth is one of the primary determinants of stocks’ P/E ratios. To examine this relationship, ETFs’ earnings growth rates have been plotted against ETFs’ Price/Earnings ratios as illustrated in the following graph.

The following table presents actual data for these 4 quadrants over a five-year period. For each year, funds’ EPS growth rates, P/Es and returns were aggregated, ranked and divided into quartiles. Quartiles of both variables were combined into the quadrants shown above. The table presents the average of funds’ aggregates for each quadrant.

As the shaded (or bold faced) areas illustrate, funds in Quadrant 1 consistently (4 of 5 years) and significantly outperformed funds in Quadrant 4. The lesson: Invest in ETFs that fall into Quadrant 1 and above all avoid ones that fall into Quadrant 4.

Calculated and reviewed correctly, fundamentals provide an essential supplement to current ETF research.