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The Stars Have Come Out for Exchange-Traded Funds

Introducing the Morningstar Rating for ETFs.

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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. Starting today, you can find them on  individual ETF reports on Morningstar.com, as well as in other Morningstar products. 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).

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.