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How to Evaluate New ETFs

Our method for ferreting out promising prospects.

Sonya Morris, 07/03/2007

The following article appeared in Morningstar ETFInvestor, a monthly publication that features our latest thinking on the ETF market.

Growth in the exchange-traded fund market has been explosive over the past couple of years. Last year, 159 new ETFs debuted. And halfway through 2007, more than 160 new funds have hit the market. It's hard to keep up with the pace of new growth, but I've developed a framework that helps me sort through the flurry of new offerings, so I can separate the wheat from the chaff. To determine whether or not a new ETF holds promise, I ask a few basic questions.

How Does It Compare to the Competition?
The vast majority of the equity universe has already been covered by ETFs that are already on the market, so how does a new ETF get my attention?

By building a better mousetrap. For example, the four new bond ETFs from Vanguard--Vanguard Total Bond ETF BND, Vanguard Long-Term Bond ETF BLV, Vanguard Intermediate-Term Bond ETF BIV, and Vanguard Short-Term Bond ETF BSV--are a definite improvement over other fixed-income ETFs. First of all, they're cheaper with expense ratios of 0.11%. With bond funds, low expenses are essential. And they are more diversified than their rivals. For example, Vanguard Total Bond Market ETF tracks the same index as iShares Lehman Aggregate AGG, but the Vanguard fund holds thousands of individual securities, while the iShares ETF holds just 130 issues. That improves the Vanguard fund's chances of tracking its benchmark more closely, and it provides shareholders greater diversification.

Two of my favorite new ETFs are attractive for hands-off investors looking to gain foreign exposure. SPDR MSCI All Country World ex-US CWI and Vanguard FTSE All-World ex US VEU came out within weeks of each other and cover very similar territory. Both offer exposure to virtually the entire investible equity universe except the United States. They are both low-cost, market-cap weighted, and track benchmarks provided by established index providers. Until these new ETFs were launched competition among broadly diversified foreign ETFs had been remarkably quiet. In fact, iShares MSCI EAFE EFA essentially owned the territory, but both new ETFs bring more to the table because they include emerging markets, Canada, and small-cap stocks--all areas the EAFE neglects. Plus, both new ETFs sport lower expense ratios than the iShares ETF.

Is the Timing Right?
ETF providers have a history of rolling out new ETFs that track the hottest markets, a practice that tends to encourage investors' worst instincts. But every market segment--no matter how hot it might be right now--will eventually fall on hard times. In fact, the hotter the category, the greater that risk. As a reality check, I try to understand how an ETF might perform in unfavorable market conditions.

To illustrate, conditions don't seem particularly ripe for the newest bond ETF, iShares iBoxx $ High Yield Corporate HYG. A market shift in the high-yield bond market wouldn't be particularly surprising. Spreads between high-yield bonds and Treasury issues of comparable maturity are trending near historic lows. That suggests that high-yield bonds are richly priced and that they aren't adequately compensating investors for their risks. If the market simply returns to historic norms, the new iShares $ iBoxx High Yield Corporate will tumble.

It's a similar situation for the lineup of emerging-markets ETFs that State Street launched in March, including SPDR S&P Emerging Markets GMM, SPDR S&P Emerging Europe GUR, and SPDR S&P Emerging Latin America GML. 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.PAGEBREAK

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