As Investors' Opportunities Grow, We Expand Ratings Universe

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Morningstar is launching analyst ratings for ETFs and I'm here with Ben Johnson, he is our director of global ETF research, to look at how these are calculated.

Ben, thanks for joining me.

Ben Johnson: Thanks for having me, Jeremy.

Glaser: So, we've had analyst ratings for open-end mutual funds for some time now, those Gold, Silver, Bronze ratings, and we're rolling that out to ETFs as well. Can you talk about why we wanted to extend this into the ETF universe?

Johnson: So, we are expanding our rated universe, the universe of funds that we assign a Morningstar Analyst Rating to. The Morningstar Analyst Rating was introduced in November of 2011. And the analyst rating, it's important to note, unlike the Morningstar Rating or the star rating, is a forward-looking assessment of a fund's prospects relative to its category peers. So, a positive rating or a medalist rating, so Gold, Silver, and Bronze, is indicative of the fact that we have confidence, varying degrees of confidence or conviction, in a particular strategy. We're saying with those ratings that this particular fund, this particular strategy, can be reasonably expected to outperform its category peers while accounting for risk over a full market cycle.

Now, why, as you asked, are we expanding our rated universe to include ETFs? Well, we're expanding our universe to reflect the fact that investors' opportunity set is expanding, and increasingly they are taking a strategy- and vehicle-agnostic view of the world. Now, what I mean there in terms of strategies is that investors are no longer looking strictly at active strategies, strictly at passive ones, or strictly at those that exist somewhere between those two poles on the active to passive continuum. They are combining a mixture of active and passive strategies in their portfolios. They are also becoming increasingly vehicle-agnostic. So, they are not using mutual funds exclusively. They are not using exchange-traded funds exclusively. In all likelihood, they are using some combination of all of the above. So, we wanted to realign and reframe our key rating. This is one of the key signals that we send to investors in helping them to make informed decisions when it comes to fund selection, to better reflect how they are thinking about their own opportunity set, which is broader than it's ever been.

Glaser: So, investors are looking at them with similar lenses. Will you be looking at them with a similar lens? Is the rating the same for an ETF versus an open-end fund?

Johnson: Our due diligence process for all intents and purposes when looking at exchange-traded funds and rating exchange-traded funds is identical to the one that we've applied now for five-plus years in doing due diligence on actively managed strategies. So, we're looking at the same five pillars that underlie that rating. The five pillars being People, Performance, Parent, Process, and Price.

Now, it's important to note that some of these pillars going to receive either greater or lesser emphasis in the case of looking at passively managed strategies than they might in the case of actively managed ones. So, I think, People is a perfect case in point. We're going to place a lesser degree of emphasis on the team that is managing a total stock market index portfolio than we might in scrutinizing the people who are at the helm of a concentrated, deep-value strategy that is actively managed.

Now, those pillars that might receive slightly more emphasis that are really the key levers of our overall rating are Price--index funds and ETFs, if they have one key advantage, it's that they tend to levy fees that are a tiny fraction the median toll taken by their category peers--and we're also going to look very closely at Process. And when we think about Process, we unpack it with two key questions, the first being how is the index underlying this ETF built? So what can we expect in terms of the end portfolio and its characteristics relative to peers? How it might perform over a given market cycle. And then we want to understand after understanding how the index is built, how the portfolio has actually managed to track that index as precisely as possible.

Glaser: When looking at performance, you would hope that index fund is providing you exposure to that index, less fees, so then how do you gauge performance if it's positive or negative? Is it just how it tracks the index? Is there how it responds or how it competes with active managers?

Johnson: So, we look at index funds and ETFs' performance through two different lenses. First and foremost, we want to see high-fidelity tracking of the benchmark index. And what you see when you look at our rated universe is that that has almost become table stakes that most funds track their index spot-on or lag by an amount that is precisely equal on a run-rate basis to the fees that they are taking. So, high fidelity, very precise tracking is really table stakes among the upper echelons of the exchange-traded funds universe.

Now, we also zoom out and look more broadly at performance relative to peers across a full market cycle. We look at absolute returns, so how has this particular index strategy performed in drawdowns? How has it performed in bull markets? We look at risk-adjusted returns because ultimately the signal that we're sending is a signal that is driven by our assessment of prospective future risk-adjusted returns. So, it's important to look at both the sort of index-tracking performance again and peer-group-relative performance, which is really central to the signal that we are sending with the Morningstar Analyst Rating.

Glaser: So, finally, what's the best way for investors to use these ratings? Should you be building a portfolio of only Gold funds? How do you think about these different ratings and put them into practice?

Johnson: Well, I think, what you can do now is easily make comparisons, again, across all different sorts of strategies, across all different types of vehicles and that is really a powerful tool, because as powerful as indexing is--and I think even more importantly, as powerful as low cost and low turnover are--index strategies are not always going to deliver what you might expect depending on the market regime, the market environment, and the asset class in question. So, what we're able to do now is signal more immediately, more apparently that there are certain asset classes, like U.S. large-cap equities, where indexing is a very solid choice for most investors. There are other asset classes, like emerging-markets equities, where by virtue of the way that the underlying indexes in many cases are made up, this is a suboptimal choice for many investors, and you might be better served by a highly rated active manager in a case in point, like emerging-markets equities.

Glaser: Ben, we certainly appreciate the update on the analyst rating today.

Johnson: Glad to be here, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.