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ETF Specialist

Our New ETF Analyst Reports: A Walk-Through

A rundown of the exciting changes we've made to our ETF Analyst Reports.

As we announced in our article, "Introducing Our New ETF Research," we've made a number of changes to our ETF Analyst Reports.

Following is a walk-through of the enhancements, starting with a general overview of the changes and then drilling down to examine the new report format and data points in closer detail.

(For a full-blown example of our new approach, check out "This Low-Cost, High-Yielding ETF Looks Like a Bargain," which contains a sample ETF Analyst Report. And to learn more about Morningstar's fundamental approach to evaluating ETFs, you can view a webcast of my February 2008 Orlando Money Show presentation. Registration with is required to view the webcast.)

To this point, our ETF analysis has focused on attributes such as cost, portfolio construction, tax efficiency, and performance. That research is no less relevant today, especially if you're aiming to construct a low-cost, efficient portfolio using ETFs.

However, we've expanded the scope of our analysis to better address an equity ETF's attractiveness based on the valuations of the stocks it owns. This allows us to identify stock ETFs that are undervalued and helps you to profit from such opportunities as they arise.

To that end, the new ETF Analyst Reports focus to a far greater extent on traits like the quality and risk of the stocks an equity ETF owns. For instance, does the fund invest primarily in the stocks of high-quality firms that boast durable competitive advantages? Or does it hold the shares of grungy businesses in commodified industries with dim growth prospects?

By addressing questions like these, we can glean insights into the factors that most directly influence a fund's intrinsic worth and the risks it courts. Those efforts culminate in a forward-looking "valuation rating" that sets forth whether an ETF is cheap, dear, or fairly valued based on our estimates.

Enhanced Report Format
To efficiently convey this information, we've restructured the ETF Analyst Report. Here's a brief synopsis of the major sections:

This is the heart-and-soul of each ETF Analyst Report. Here you'll find a concise, but meaningful summary of an ETF's bona fides.

For stock ETFs, that discussion will typically revolve around topics such as the portfolio's quality (which dictates the fund's intrinsic worth) and the riskiness of its holdings coupled with the level of diversification across securities and sectors. (Taken together, these factors determine the discount to fair value, or "margin of safety," we'd demand before recommending purchase of the ETF.) From reading the report thesis, you should be able to discern why an ETF is more, or less, valuable than other funds. In addition, you should be able to suss out the fund's risk profile and, in turn, the margin of safety we'd demand before investing in it.

For bond funds, commodity funds, and certain types of stock ETFs, the thesis will evaluate the ETF's merits under the traditional framework, considering attributes such as cost, portfolio construction, tax efficiency, performance, and the like.

Analyst Note
Here we'll typically set forth details regarding an ETF's valuation. For instance, does it look cheap, dear, or reasonably priced at recent levels?

We'll also use the notes to keep you apprised of pertinent developments. For instance, we'll typically dash off an Analyst Note if a big holding swoons or a Morningstar stock analyst jacks up his or her fair value estimate on a key name.

Fees are a key differentiator in the ETF world; the lower a fund's expense ratio, generally speaking, the better. In this section you'll find commentary on an ETF's expenses. For instance, are they high or low in absolute terms? Cheap compared with open-end mutual funds? What about comparable ETFs?

We'll also use this section to examine a stock ETF's cost of equity capital. Just as there's a percentage cost to tie up your money in Treasuries or even deposit accounts, there is also a cost to holding a stock. This is referred to as the stock's cost of equity (COE), which compensates you for the intrinsic risk courted by the firm. We estimate an ETF's COE by aggregating the COEs of its underlying holdings.

Portfolio Construction
Whether you're using ETFs to build an efficient, low-cost portfolio or to opportunistically invest in certain market segments that look undervalued, portfolio construction matters. For instance, what index does the ETF track? How concentrated or sprawling is the portfolio? How does the fund weight its holdings? What biases does that approach introduce?

This information should help portfolio-builders determine how an ETF might, or might not, fit into an asset allocation and what influence it might have on the portfolio's overall risk/reward profile.

By the same token, the portfolio's quality and risk attributes are also key elements in the "Thesis" section. For instance, our estimate of an ETF's intrinsic worth is a function of what the fund owns and in what proportion, which in turn depends on the index's construction.

Bulls Say/Bears Say
In this section, we provide a short, bulleted list of the pros and cons associated with a particular ETF investment. For instance, is it cheap? Is the portfolio high-quality? Has it tracked its benchmark faithfully over time? Has the fund made capital gains distributions in years past? And so forth.

Innovative Data Points
In addition to revamping our ETF Analyst Report content and format, we've introduced a suite of new data points that will greatly enhance your ETF research. Here's a rundown:

Valuation Rating
For stock ETFs where we cover a significant number of the underlying portfolio holdings, we'll often provide a valuation rating. That rating will clearly set forth the attractiveness of an ETF's valuation using one of four terms--undervalued, overvalued, fairly valued, and not rated.

A stock ETF's rating will depend on its valuation and risk. Following are the valuation breakpoints that we'll use for purposes of determining each ETF's rating. (A fund's price/fair value ratio expresses its valuation as a quotient; therefore, the lower a fund's price/fair value ratio, the cheaper it is, and vice versa.)

 ETF Valuation Rating Breakpoints
Risk Undervalued Fairly Valued Overvalued
Low <= 0.92 0.93 to 1.06 >= 1.07
Below Average <= 0.85 0.86 to 1.12 >= 1.13
Moderate <= 0.80 0.81 to 1.21 >= 1.22
Above Average <= 0.72 0.73 to 1.33 >= 1.34
High <= 0.55 0.56 to 1.51 >= 1.52

ETF Fair Value Estimate
Not to be confused with an ETF's net asset value (which is the literal value of a fund's holdings based on quoted market prices), an ETF's fair value estimate represents what we think its holdings are worth in the aggregate.

Our estimate of an ETF's intrinsic worth is predicated on the fair value estimates that our equity analysts have placed on the fund's holdings. By aggregating these fair value estimates, we can derive an estimate of the ETF's intrinsic worth.

To estimate a firm's fair value, our analysts forecast its cash flows into the future and then discount those projected cash flows back to the present.

What influences a firm's projected future cash flows? The biggest driver, in our view, is its competitive standing. Firms that boast defensible competitive advantages are able to consistently churn out economic profits while keeping rivals at bay. These higher-quality firms, which we denote with a "wide" economic moat rating, are more valuable than their less-dominant counterparts.

Thus, an ETF that owns a greater share of wide-moat firms than another fund will be worth more, on balance, and vice versa. That's why we'll emphasize portfolio quality again and again in our reports--this is the single-most important determinant of an ETF's intrinsic worth.

By comparing an ETF's estimated fair value with its market price, we can determine whether the fund is overvalued, undervalued, or fairly valued.

ETF Expected Return
This is the annualized return that an investor should earn if an ETF's price converges to our fair value estimate over a three-year time horizon. Generally speaking, the more undervalued an ETF, the higher its expected return, and vice versa.

Using this data point, investors should be able to more-precisely quantify the potential upside associated with an ETF.

ETF Hurdle Rate
An ETF's hurdle rate is the sum of the portfolio's weighted-average cost of equity, the fund's annual expense ratio, and, in certain cases, an incremental risk premium.

An ETF's hurdle rate represents the hurdle that a fund must clear in order to provide excess returns on a risk-adjusted basis.

ETF Excess Return
This is the difference between an ETF's expected return and its hurdle rate and can be positive or negative depending on the fund's valuation. Since this is a risk-adjusted measure, you might think of this as "alpha."

Generally speaking, ETFs trading at a more-than-nominal discount to our fair value estimate will generate positive excess returns while those trading at a premium will earn negative excess returns.

Here's a useful rule-of-thumb to keep in mind when you're surveying ETFs' expected excess returns: We'll recommend (i.e., place an "undervalued" rating upon) any ETFs that we expect to deliver 3%-plus excess returns, irrespective of risk.

For example, as of this writing, we'd expect  Financial Select SPDR (XLF) to generate a 22.4% annualized return based on a comparison of the fund's price to our estimate of its intrinsic worth. That ETF's hurdle rate is roughly 14% (sum of the fund's 10.8% cost of equity, 0.24% annual expense ratio, and an approximate 3% incremental risk premium). Given that the fund's 8.4% risk-adjusted excess return--22.4% expected return less its 14% hurdle rate--is greater than 3%, we're currently recommending it.

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