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Five Overlooked 5-Star ETFs

Scott Burns

Scott Burns: 5-Star ETFs that investors are overlooking. Hi, there. I'm Scott Burns with Morningstar. Joining me today is Paul Justice, our Director of North American ETF Research.

Paul, thanks for joining me.

Paul Justice: Pleasure.

Burns: So I think, the first thing on viewers' minds is a 5-Star ETF, isn't that a bit inconsistent, how can an ETF be 5-stars, isn't it just an index?

Justice: Well, for the most part ETFs are index funds. But an index can go far beyond just market cap weighting. Most ETF insiders know this already that there is wide swath of opportunities, equal-weighted, market cap-weighted, fundamentally-weighted, some of them driving up from quantitative factors. And what we've seen is a great deal of outperformance by a lot of these quantitative ETFs, the ETFs that are applying additional screening besides the most basic aspects of stock investing.

Burns: What are some examples of those screens?

Justice: Well, before I get into it too much, I'd like to say what we're really looking for. So there are several 5-Star ETFs on the market, and we compare them against the whole open end mutual fund world. What we decided to do was, make sure that we're looking at it by asset class to start with, and we picked out five large cap ETFs that have achieved 5-Star ratings and the reason being is, we've seen so much market commentary from very well-know investors talking about how large cap stocks right now are presenting a compelling value.

Bill Miller, for instance, has come out and said that large caps look like the opportunity of a lifetime right now. We've also seen commentary from folks like Jack Bogle and Longleaf Partners talking about how equities are relatively cheap compared to bonds these days. Even Jeremy Grantham is looking kind of in the high quality space of the equity world to find better returns over the next several years. So, when we went into our screens we looked at the large cap space based on that, identifying that – the segment of the market that we wanted to hit, and then sort it out by the performance against the peers.

Burns: So, when we look in this large cap space, we do have a couple standouts. So, what are the funds from top to bottom in terms of their star rating and historical risk-adjusted returns?

Justice: Sure. All of these are going to be 5-Star rated funds, and the two standouts at the top that have over $2 billion invested in them already, it is a Morningstar favorite fund, it's Vanguard Dividend Appreciation Fund, the ticker is VIG. And it's giving you that large cap core exposure, really driving into the high quality equity segment. We think that this is a great way to fill what – you deem to be the high quality segment based on all the screens that Vanguard and Mergent has put this fund through. We think it can be a great core holding in a portfolio.

And also is the SPDR S&P Dividend Fund, and that's going to screen through the S&P 1500 for the stocks that have above-average dividend yields and a long track record of dividend growth, so it's going to give you a nice core income component to your equities. And again, you've got great deal of market liquidity there, and it could be another great component to really give your portfolio kind of that value to producing a lot of income, granted it does venture into the mid cap space a bit, but it's still mainly a large cap focused fund.

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Burns: We've spent a lot of time looking at both of these funds, and they really do have different approaches, they even have different yields. And it's remarkable that they've both managed to turn out this really best-in-class type performance.

Justice: Sure. And in all indications I don't see why they can't continue to perform well against their peers. We did come up with three other funds that are mainly overlooked, and I think that looking at the performance record, they really should be on investors' radars at this point in time.

One of the ones that really stands out to me, there's the PowerShares Dynamic Large Cap Value Fund, and this is a fund that's got a pretty complicated algorithm behind it. They can look at over 20 factors when determining what stocks are going to pick up that exposure to. But investors have noticed, it's got over $300 million in assets, and it's really beaten the category group by over 8 percentage points here over the last five years. And I think that this is something that investors really should look into.

We also saw our First Trust Value Line Dividend Index, and this is a smaller fund, it's just over $100 million in assets with the famed value line investing methodology behind it. That's really driven home some strong performance from one of the smaller ETF providers, but it goes to show that some of these products really do have some merits, if you're going to be looking around out the large cap exposure.

Burns: Yeah. It definitely seems like some of these models really are delivering. How can an investor, when they're looking at these models really try to make some determination, what was in the past, how will that – how do I get comfort that that will continue going forward?

Justice: Well, I wouldn't expect outperformance in every year for sure. There's going to be certain instances when some strategies are going to perform well relative to others. Right now, that's kind of our baseline, when we're deciding beyond our asset location, what funds we want to have exposure to? We're already talking about the large caps base. So then I want to dive in and see if the methodology really matches up with my kind of investment thesis or where the economy stands today and what factors are going to drive that performance. Now value versus growth, small versus large, those are just some of the lenses we look at, at Morningstar to really kind of find where the value is going to be.

Burns: Well, and some of the more, Intellidex or intelligent indexing type funds like from PowerShares and First Trust, they added momentum factors and other things like that as well. So, there is a lot to consider.

Justice: They're extremely complex. I mean, I don't know that I could dive in on all 20-plus factors on the PowerShares fund and recognize which ones are really driving performance today, or if it's going to stock pick its way or sector picks its way into high performance. What I can really do though is look at the past performance, and see how did it perform relative to the peers, especially in the risk-adjusted return space, which the star rating does capture.

Burns: All right. Are there any others out there that investors should be thinking about?

Justice: There is one more. It's – unfortunately it doesn't have much money in assets, so you have to be very careful when you're going in, in your capital markets decision. But there is the Claymore/Sabrient Defensive Equity Fund, only at $14 million in assets, but clearly has delivered on this defensive promise that it's kind of laid out in front of investors. Is defensive going to be a good place to be if the market decides to go on a long-bull run? No. But it's offered you some protection and really gave you the better risk-adjusted returns within the category.

Burns: Yeah, I mean, there is always a place in a portfolio I think in a broader asset allocation sense for some defensive positions. So, this definitely seems like a unique fund, and the fact that it has been able to deliver over the past certainly speaks volumes, especially given everything that's happened for its construction and its methodology.

Justice: I agree.

Scott Burns: All right. Well, Paul, thanks for bringing that to my attention and to investors intention. For this and other ETF news and research please check out the ETF Center on morningstar.com and Morningstar's ETFInvestor newsletter. Thanks.