The Stars Have Come Out for Exchange-Traded Funds

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In an effort to shed a little light on the choice between exchange-traded funds and conventional mutual funds, Morningstar has introduced star ratings for ETFs. We think the ratings will provide investors with a familiar tool to gauge ETFs' risk-adjusted returns and compare them with those of conventional mutual funds, as well as other ETFs.

Star Gazing

Like the star rating for traditional funds, the Morningstar Rating for ETFs is a purely objective, mathematically derived measure based on funds' past risk/return profiles. For the most part, this is the same star rating you're probably familiar with, though we made some accommodations for the unique nature of ETFs. We're adjusting ETF returns for brokerage commissions, just like we adjust traditional open-end fund returns for sales charges. We treat ETF commissions like front- and back-end loads of 0.2%. (That assumes investors paid a $20 commission on a $10,000 investment, or $40 to buy and sell.) Investors can pay lower or higher brokerage fees when trading ETFs, but they can't avoid them, so we deemed it appropriate to factor commissions into the rating.

Because many ETF categories remain too thinly populated to make meaningful comparisons, we rate ETFs against the conventional open-end funds in their respective categories as well as other ETFs in their peer groups. Thus, an investor can readily compare how a conventional index fund such as Vanguard 500 Index VFINX compares with its ETF competitors, such as the SPDR SPY.

Comparability is also one of the reasons we're using ETFs' NAV total returns--as opposed to their market price total returns--as the basis for the ratings. ETF market prices, which are set throughout the day by supply and demand, tend to stick pretty close to their NAVs, which are set at the end of the trading day. Furthermore, market prices can be stale for ETFs that don't trade often, making the ETFs' NAV return a better indicator of performance in those cases.

Constant as a Star

Beyond those notable differences, it's the same old rating.