Strategic-Beta ETFs Seeing Stars

We are all familiar with the saying that past performance is no guarantee of future results. But that doesn't stop investors from picking funds this way. Before fund data became widely available and in order to facilitate meaningful comparisons, Morningstar developed a performance measure called the Morningstar Rating for funds. Unfortunately, some investors heavily rely on it when picking new funds, and investment flows consistently accrue to 4- and 5-star funds. However, the star rating is only one tool to evaluate funds, and it was not designed to have predictive ability about future performance. Certain characteristics that correlate with the rating, such as fees and risk, tend to persist, while performance is fleeting. 

Given their attractive performance, strategic-beta funds--index funds that make active bets--have attracted a lot of attention. It is only natural for investors to want to evaluate a live performance record before investing rather than blindly trusting a back-test. It is common for investment consultants to wait until an active manager has at least a three-year track record before investing. Many strategic-beta exchange-traded funds now have records of more than five years, and their performance has been pretty good. The Morningstar Rating for funds is one tool investors can use to evaluate their performance. However, before we look at that rating as applied to strategic-beta ETFs, it is important to understand what it is and how it differs for ETFs and mutual funds.

The Morningstar Rating ranks funds based on risk-adjusted return compared with funds in the same Morningstar Category. Funds are given 1 to 5 stars, and the distribution of stars approximately follows a bell curve, with just 10% of funds receiving the highest 5-star or lowest 1-star ratings and 35% receiving the middle rating of 3 stars. The rating is a quantitative assessment of past performance and not an opinion about future performance. Morningstar is completely transparent with the methodology and does not have any editorial input into individual ratings. All funds with at least a three-year record are ranked, except for those in a handful of categories, such as alternative categories or categories that do not have enough funds to form a valid comparison group. 

The chart below illustrates the bell-curve distribution of ratings for 6,088 share classes of 1,811 U.S. equity mutual funds. Just 29% of funds had 4- or 5-star ratings. It is important to note that ETFs are ranked separately, after mutual funds are ranked and the breakpoints are determined. This was done back when there were too few ETFs to rank among themselves. Consequently, strategic-beta ETF ratings do not have to follow a bell curve, and indeed they do not, as 63% of the 51 non-strategic-beta U.S. equity ETFs and 76% of the 92 strategic-beta U.S. equity ETFs have 4- or 5-star ratings.

Source: Morningstar Direct.

Source: Morningstar Direct.

The star rating is based on a ranking of the Morningstar Risk-Adjusted Return. This starts with the Morningstar Return, which is the load-adjusted return in excess of the risk-free rate. ETFs benefit because they do not charge loads while many retail share classes of mutual funds do. ETFs also benefit from lower expense ratios, which is one of the biggest determinants of relative performance. The tables below show some characteristics of funds with each rating. The average expense ratio for U.S. equity mutual funds with a rating of 1 star is 1.62% compared with 1.11% for funds rated 5 stars. The expense ratio advantage of ETFs is clear: Even the lowest-rated ETFs have lower expense ratios than the highest-rated mutual funds. 

Morningstar Risk uses a risk adjustment that penalizes downside risk more than upside volatility in assigning risk scores. Lower risk values are better. On average, ETFs have less risk than the average mutual fund, but many equity mutual funds maintain a small cash position that helps to buffer downside volatility. While fully invested ETFs can make up for the higher downside risk with better upside capture, the utility function for the rating more severely penalizes downside risk. This penalty results in a higher risk and a lower ranking for many ETFs compared with mutual funds that have the same level of volatility. Morningstar Risk-Adjusted Return combines both the return and risk through a utility function with an assumed level of risk aversion appropriate for the average investor.

While past performance may not tell you everything you need to know, it can be a useful data point among others in a more comprehensive analysis. In contrast to the historical performance rating, the Morningstar Analyst Rating is based on a five-pillar framework that evaluates a fund's prospects. These pillars include Price, People, Parent, Process, and Performance. Investors should evaluate the suitability of a fund in the context of their portfolio and their investing objectives. It is also important to have a fundamental view on the economic case for the fund if it is a short-term tactical holding, rather than a long-term buy-and-hold investment. 

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