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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

Similarly, many alternatively weighted ETFs, such as fundamental or equal-weighted ETFs, emphasize the smaller stocks in their universes. Accordingly, these funds are likely to do well when small caps are in favor, and vice versa. But a look at the price/fair value ratios for each market-cap segment shows that the biggest stocks boast the most attractive valuations at the moment, so I've been drawn to traditional market-cap weighted benchmarks lately because they lean toward the bigger stocks.

The previous examples show that casting a contrarian eye toward current market conditions can help you gauge if the time is right for a new ETF. You can also turn to the valuations of the ETF's underlying holdings as a useful guide. A study of valuations is the primary underpinning of my ETF strategy.

I'm skeptical of many of the new untested benchmarks that many of the new ETFs track, but I would still give one of these funds a hard look if its price/fair value ratio and average stock star ratings are compelling. (These data points are available to subscribers of Morningstar ETFInvestor. To learn more, click here.) For example, WisdomTree recently came out with a batch of earnings-weighted ETFs. I'm somewhat skeptical of that methodology because earnings might not always be a reliable gauge of a firm's size. For example, earnings can fluctuate significantly for cyclical firms, and earnings are also vulnerable to accounting trickery.

But despite those shortcomings, I have to admit that the valuation characteristics of WisdomTree Earnings 500 EPS, a new ETF that debuted in February, hold up to scrutiny. It dedicates slightly more assets to 4- and 5-star stocks than the S&P 500, and its average stock star rating and price/fair value ratio of 3.05 and 0.98, respectively, suggest that it's slightly cheaper than the S&P 500. That makes it worth keeping an eye on (though it doesn't yet elevate it to the level of a pick).

On the flip side, PowerShares DWA Technical Leaders PDP, an ETF that launched in March, provides an example of an ETF that doesn't look compelling right now from a valuation perspective. The ETF tracks the Dorsey Wright Technical Leaders Index, which is a basket of approximately 100 stocks that exhibit strong relative strength characteristics. That is, it prefers stocks that have historically preformed better than the market as a whole as well as industry peers. I'm not a fan of relative strength--or momentum--investing. It 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. It dedicates less than 4% of its portfolio to 4- and 5-star stocks, while 1- and 2-star stocks consume 43% of assets.

Does the Benchmark Employ a Methodology That Makes Sense?
As my discussion of the previous ETF indicates, benchmark construction often plays a role in my evaluation of an ETF. It was one reason I have been drawn to iShares S&P Global Healthcare IXJ. All the other health-care ETFs track benchmarks that exclude firms based outside the United States. In my opinion, that's an unreasonable and unnecessary limitation in a global industry like health care. I'd rather have exposure to the entire sector and big foreign-based health-care firms, like Novartis NVS, that look compelling based on Morningstar's stock research so I prefer the ETF with a global reach.

A similar factor influenced my recommendation of iPath DJ-AIG Commodity Index DJP. Most commodity ETFs are heavily weighted toward oil. In contrast, DJ-AIG Commodity Index limits the weighting of any one commodity sector to 33% of assets, which keeps energy from dominating the portfolio. Because I plan to use the ETF for diversification purposes that composition makes more sense to me.

Because most major index providers have covered virtually all the equity ground, new firms seeking to find a niche in this fast-growing ETF market have sometimes taken more creative paths. Because these indexes are untested, I approach them with a healthy dose of skepticism, particularly those with methodologies that include factors that are more qualitative than quantitative. One such fund is the new Claymore/Great Companies Large-Cap Growth Index ETF XGC, which tracks a benchmark that considers issues such as quality of management and the firm's record of retaining high-performing employees. Those are traits that are difficult to quantify or to even find the data to support. To be convinced, I'd need to see evidence that this methodology can successfully identify undervalued stocks. And early indications are mixed. Just eight of the ETF's top 20 holdings are ranked either 4 or 5 stars by Morningstar equity analysts.

Sonya Morris is an analyst with Morningstar.

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