The Inaugural Morningstar Awards for ETFs

At Morningstar, one of our key mandates is to boil the often-confusing world of investing down to a consumable assortment of the best funds. When it comes to exchange-traded fund investing, we do this largely through our ETF Analysts' Favorites (available to Morningstar Premium subscribers here) and the Morningstar Ratings. However, the ETF Analysts' Favorites list is based on a largely qualitative assessment of the ETF that considers the ETF's role in the portfolio as well as such factors as expenses, index construction, tax efficiency, and diversification. The Morningstar Rating is based on a quantitative assessment of an ETF's historic monthly risk-adjusted returns against its category average.

The new Morningstar Awards for ETFs are based on a purely quantitative process that measures an ETF’s ability to track its index and the ease of tradeability. The awards place less emphasis on historic returns. After all, by investing in an index-focused ETF, investors are expecting to get returns somewhere in the ballpark of the index. Therefore, their focus is on other factors that can cause their ETF’s returns to deviate from the index’s. These factors include an ETF’s ability to match its index with minimal expenses, tracking error, and trading costs.

For each of the 37 categories with enough ETFs to qualify, we have awarded both a retail and an institutional winner. The category winners are intended to highlight the use of Morningstar data to assess the suitability of ETFs for different investors, who likely have different investment time horizons and a varying need for liquidity. A buy-and-hold retail investor should place a heavy emphasis on low-fee investing, because in the long term, fees tend to be a great predictor of returns. On the other hand, because an institutional investor is likely to invest a larger sum of money, he is more likely to place a greater emphasis on liquidity. For institutional investors, trading costs can quickly trump any cost savings arising from lower expense ratios. In light of the differing needs of these investor groups, Morningstar is giving two awards to ETFs in each eligible category: a retail award, which places greater emphasis on holding costs, and an institutional award, which places greater emphasis on market impact costs. The exact methodology for the category awards can be found here.

Examining Several Category Winners to Illustrate the Methodology
We are pleased to announce that, in the large-blend category, Vanguard Total Stock Market ETF VTI won the retail award, while SPDR S&P 500 SPY won the institutional award. This category’s winners provide a great illustration of why each category has both a retail and institutional award.

VTI is the quintessential ETF. It holds virtually the entire U.S. stock market for the incredibly low cost of just 0.06%. In fact, over the one-year period ended June 30, 2012, VTI underperformed its index by only 0.03%, costing investors even less than its stated expense ratio, while providing adequate liquidity and tight tracking to its index. However, it trades only about 1.9 million shares (or $140 million in value) per day, making it less suited for institutional investing relative to SPY.

By contrast, as the institutional award winner for this category, SPY trades $25 billion a day, offering tremendous liquidity. Because the market impact score weighs so heavily on the methodology for the institutional award, it is no surprise that the institutional winner in the large-blend category is also the most liquid ETF on the planet. As a unit investment trust, SPY follows a slightly more restrictive legal structure than do its regulated investment company competitors. Still, its large asset base allows it to track its index efficiently, with a tracking volatility of just 0.03%. Although at an estimated holding cost of 0.10%, SPY is not the lowest-cost way to track the S&P 500 Index (that distinction belongs to Vanguard S&P 500 ETF VOO, which had a 0.03% holding cost), it is cheaper to trade. We estimate that a $1,000,000 trade in SPY would cause just $4 in market impact or trading costs, whereas the same size trade in VOO would cost $89.

In the small-blend category, Vanguard Small Cap ETF VB won the retail award as it actually outperformed its index by 0.05%. How can an ETF outperform its index? If the ETF follows a representative sampling approach instead of full replication, it might outperform by chance. But that is probably not the case here, as VB had very tight tracking to its index. The more likely explanation is securities lending. VB earned more than $4.5 million in securities lending in 2011, which was more than enough to offset its expenses.

In the institutional category, iShares S&P SmallCap 600 Index IJR is the winner, despite the fact that it is not the most liquid choice. In most categories, the most liquid ETF typically wins the institutional award because the methodology is heavily weighted toward the market impact score. In the small-blend category, iShares Russell 2000 ETF IWM is by far the most liquid, trading nearly $4.5 billion a day or 30 times as much as IJR. However, the awards methodology also incorporates risk-adjusted return. For the three-year period ended June 30, 2012, the S&P Small Cap 600 outperformed the Russell 2000 by nearly 2% on an annualized basis. This large performance difference was enough to give IJR the edge. In other words, in this case, it wasn’t the market impact but the underlying index that won the day for IJR.