We're pleased to announce the ETF Provider Awards and the 74 Retail and Institutional category winners for 2012.
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 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
In the small-blend category, Vanguard Small Cap ETF
In the institutional category, iShares S&P SmallCap 600 Index