Six Principles for Smart ETF Investing

In September, Morningstar will launch its newest monthly publication--Morningstar ETFInvestor. In the following article, Sonya Morris, the newsletter's editor, outlines her innovative, fundamentals-based approach for making money in exchange-traded funds. For more on Morningstar ETFInvestor and to learn how to preorder the first issue, please clickhere. With your first issue, you'll receive three free reports: The ABCs of ETFs, Choosing ETFs the Morningstar ETFInvestor Way, and The ETF Numbers that Matter--and Why.

ETFs can be great tools to add to your financial toolbox. They're cheap, flexible, and tax-efficient. But to benefit from what they have to offer, you must use them intelligently. That means resisting "short-termism" and avoiding the temptation to pile into the hottest performing funds. As editor of our newest publication, Morningstar ETFInvestor--which is set to debut in September--I plan to apply the same kind of long-term, valuation-sensitive thinking that my colleagues and I employ in our analysis of stocks and mutual funds. In fact, I'll be flanked by Morningstar's team of 90 equity analysts and 25 fund analysts. Morningstar's unique expertise in both arenas will help me marry the two disciplines to offer a distinctive view on ETF investing. Read on for more on the underlying philosophy behind the newsletter.

To truly tap into all that ETFs have to offer, I think a successful investor must:

Adopt a Contrarian Point of View
You should be skeptical of the funds that attract scads of cash and generate a lot of buzz. View a fund's popularity as a warning sign rather than an invitation, and remember that eye-popping returns--while alluring--are simply not sustainable over the long haul. Too many investors pile into the hottest performing fund just as it's about to cool down. On the other hand, many of the smartest and most successful investors look for opportunities in hidden or unloved corners of the market. We've found that it pays to go against the grain. Our studies have shown that the stock-fund categories with the greatest outflows usually trump the most popular categories over the next three years. I think the best ideas are often lurking where few people are looking. That's why you'll often find me directing investors away from the most popular market segments, such as energy and real estate, to areas that can't seem to get any love, like technology and mega-caps.

Be Valuation Conscious
Smart investors look for opportunities where there's a mismatch between a stock's price and its true worth. That's why Morningstar's stock analysts spend their time trying to identify stocks that trade at prices that don't adequately reflect their fair values. Similarly, there are times when an ETF's price gets out of whack with the fair values of the securities it owns. I'll rely on Morningstar's equity analysis to identify those opportunities and to uncover funds that hold large slugs of stocks that, in our analysts' views, are trading at attractive prices. Along with my recommendations for long-term core holdings, each issue of the newsletter will also include opportunistic plays where an ETF's price is out of step with our view of the portfolio's cumulative fair value.

Pay Attention to the Fundamentals
My colleagues and I like fund managers who have a deep understanding of the financial characteristics of the companies in which they invest. Similarly, our stock analysts cull through financial statements to gain a clearer understanding of a firm's health. You can approach ETF investing in the same way by paying attention to the underlying fundamental data on the fund and its holdings. I favor ETFs that hold sizable stakes of financially sturdy firms that generate respectable growth rates and returns on equity. By sticking with quality holdings, it's easier to weather near-term bumps and maintain a long-term view.

Be Cheap
The vast majority of ETFs are index funds, and the whole premise of indexing rests on keeping costs low. In that way, they gain an edge over the typical actively managed fund. There's no reason to pay up for an ETF if you can get essentially the same exposure at a lower price. I'll only consider paying up (and only just a little) if an ETF offers something truly unique and compelling. For example, most broadly diversified large-blend ETFs cover the same ground, and therefore, I don't expect their long-term performances to differ dramatically. So I prefer the cheapest of the lot-- Vanguard Large Cap ETF (VV). By the same token, there's no reason to pay 0.60% for  PowerShares Dividend Achievers (PFM) when Vanguard offers an ETF that provides similar exposure for less than half that price.

It's also important to be cost-conscious when it comes to brokerage commissions. Because brokerage fees can quickly swamp an ETF's low-expense advantage, it pays to keep trading to a minimum. Most of my recommendations will be focused on ETFs that you can own for years.

Understand an Index's Construction Methodology
It's important to grasp how an ETF's benchmark is constructed so that you can predict how it might look and behave in the future. To illustrate, I think investors have reason to be wary of  Rydex S&P Equal Weight (RSP) because its construction methodology causes it to emphasize smaller and cheaper stocks than other large-cap market-cap-weighted ETFs. There's nothing wrong with equal weighting, per se, and it has certainly been a boon to the fund in recent years. However, it could weigh on returns when large-growth stocks return to favor, a development that many respected fund managers have been anticipating for some time now.

Maintain a Long-Term Mind-Set
Sometimes it seems that the markets are growing more and more short term in focus. Quarterly earnings reports get way too much media hype. And many fund managers I talk to report that much of the trading in the market is short term in nature. I think you can gain an advantage by bucking this trend. In other words, be a contrarian in your time frame as well. Maintain a long-term focus, and buy to hold. In my opinion, when it comes to trading, less is more. That's particularly important for ETF investors, because you pay brokerage commissions each time you trade an ETF. Remember that commission costs can quickly eat away your investment profits.

Another key ingredient to long-term thinking is patience. Long-term investors can't afford to get rattled by short-term setbacks. Very few good investment ideas pan out immediately; most need time to ripen. To be successful, you must have the patience and discipline to stick to your guns as long as the fundamentals remain in your favor.

There you have it--the principles that form the foundation of my investment philosophy. They will undoubtedly inform the content and investment ideas that appear in Morningstar ETFInvestor. To learn more about this upcoming publication, please click here.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.