Writing the User's Guide for ETFs

On Thursday, members of Morningstar's ETF research team will present "Hot Topics in ETFs," looking at issues like commodities ETFs, ETFs' role in the Flash Crash of May 6, and fixed-income ETFs, among other things. Director of ETF analysis Scott Burns and Morningstar ETF strategists Paul Justice and John Gabriel sat down recently to discuss their take on the ETF universe today.

Question: How has Morningstar's ETF research evolved over time?

Scott Burns: In the beginning we started with research as the focus, and research is still a huge focus for us, but we realized that research presumes understanding, and that there was actually still quite a large education gap. So what we're really focused on right now is an education and research mission and delivering the full solution set. There's naturally a bit of education in every piece of research, and vice versa, but in the beginning I don't think we had a fully fleshed-out concept of what it was that people needed. And that's true whether it's individuals, advisors, or institutions--people are still working up the learning curve.

Paul Justice: I think it's promoting the discovery process. People go to research reports typically because either A) they own the fund, or B) they're thinking about owning the fund. And what we've tried to do is promote the ideas around why people should look at ETFs to find solutions for their asset-exposure needs and helping them understand when an ETF can be beneficial either as a mutual fund or a single-stock replacement. And I think serving that diverse audience is key.

Q: Has ETF knowledge improved?

SB: I think that the amount of investors who are past that 101, 201 stage has increased, but there's still a lot of very early adopters. So we find ourselves having to go back over a lot of the same issues, and that's always going to be true. I always like to talk about mutual funds. We all take it for granted now that people, at least advisors and more-sophisticated investors, understand things like the Morningstar Style Box, and mutual fund returns, and how to use a mutual fund, and what they are. But if you go back to 1992, that wasn't true, and Morningstar played a huge role in that and played a huge role in creating the self-directed investor and the independent advisor. So we're looking to continue that mission for this different set of vehicles.

John Gabriel: ETFs have been around for 20 years, but like Scott was saying, we're still in the adoption phase--there's a lot of people still coming to them. So we might have got the first wave, but there's always a steady flow of investors coming in all the time, and a lot of them are coming from mutual fund investing, too, so that's why there are so many issues we can touch on, especially with the capital markets and trading.

PJ: ETFs are all the rage right now. They're still less than a tenth of the size of mutual funds, but they've been growing extremely rapidly. If we look back at 2005, ETFs crossed the $200 million mark. Now we're looking at, what, a trillion in assets under management? The number of products has grown exponentially as well. There are so many asset classes you can get exposure to, so many index styles. They've really created this new segment of products, and they will allow people to become their own active indexers.

Q: You guys were really early to sound the alarm about leveraged ETFs. Are there any pitfalls that have been exposed that people should look out for now?

PJ: What we've highlighted over the last two years is some of the weaknesses of commodities as an investment asset class. And it's really because the back-testing that was done, in a great study by Rouwenhorst and Gary Gorton in 2005, looked at a time period from 1959 to 2000, when not that many people were investing in commodities, and they didn't anticipate the market impact of financial investors going into that space and distorting the entire market. For many commodities, you have to use futures, and now futures markets are entirely distorted. I don't know that commodities make a lot of sense right now as a portfolio diversifier, unless you're holding physical underlying [goods], and it's been the case for three years running, no matter what prices do.

SB: The capital-markets aspect for ETFs was always there, but we've had some things that have exposed some issues. ETFs did extremely poorly in the Flash Crash, and these things exposed some bad investor behavior that was going on that we weren't aware of--people using stop-losses and things like that on investment funds, not trading funds. That kind of stuff has its merits in trading, but if you're investing, putting a 20% out of the money stop-loss on the total world stock market is a bad idea (laughs). Why would you do that?

When you look at the back half of 2010, continuing education on the capital markets aspect of ETFs is going to be at the forefront for us, much like leveraged ETFs were in 2009.

PJ: ETFs require just a slightly higher level of sophistication than mutual funds do. Traditionally, people have either been only mutual fund investors or stock investors. With ETFs you have to develop a new skill set that encompasses aspects of both. That's the education effort that I think we need to further going forward. I think ETFs got a negative stigma from the Flash Crash. They are not perfect, but they remain viable and good products, and they are a great solution for many people, if the ETF is available to cover the asset class that they want to get into.

I think that's the key reason why every research report we write starts off with a suitability assessment. Not all these products are right for everyone. In fact, most people should ignore 90% of the ETFs that are available and find the ones that are right for them. Are leveraged ETFs bad for everyone? No. They're right for a very small portion of the population. It would be difficult to educate the general public on how to use these appropriately, and so our efforts are more or less tied to educating the public on which ones they should be using the most often.