A Deeper Dive on Our New ETF Analyst Ratings

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We recently launched the Morningstar Analyst Rating for ETFs, and I'm joined by Ben Johnson, he's our director of global ETF research, to take a deeper dive into some of this first wave of ratings.

Ben, thanks for joining me.

Ben Johnson: Glad to be here, Jeremy.

Glaser: We're launching this rating in the U.S. with about 100 funds under coverage. When you look at this first group, what's kind of the state of ETFs? Do you think that most of these funds are pretty well positioned right now?

Johnson: Well,I think if you look at the first 100 funds that we're rating, there's a bit of selection bias inherent in the subset that we've chosen to rate right out of the gate. So, these 100 funds are almost uniformly some of the largest, the most liquid, the lowest cost, the most broadly diversified ETFs in the universe of now 1,900-plus exchange-traded products. So, the distribution of ratings skews very positive. And again, that's evidenced by the fact that there's a bit of selection bias that we really want to draw investors' attention to those funds that we think are the cream of the crop.

Glaser: So, let's take a look at some categories that investors have been interested in and what some of our favorite ideas are. Let's start with U.S. equities. You know large-cap is an area that a lot of people just want to index and they don't want to have active management in that area. What are some of our favorite funds that cover U.S. equities?

Johnson: Well, as you alluded to, Jeremy, if you look at U. S. large-cap equities and the U.S. equity market at large, especially in the current bull market it's been exceedingly difficult for active managers to consistently add value relative to index options. So, some of our favorite, in the U. S. large-cap space, possess all the hallmark characteristics of everything that's good about indexing. So, they are very broadly diversified, and they're very low cost, and they are sponsored by sound, solid parent firms. So, atop the pile there we have three total-stock-market ETFs. So, we've got the Vanguard Total Stock Market Index ETF, the ticker for that is VTI. We have the iShares S&P Total Market ETF, the ticker for that is ITOT. And then last we have the Schwab U.S. Broad Market ETF, the ticker for that one is at SCHB.

What you see among these three funds is first and foremost, insanely low fees--5 basis points for the Vanguard fund and 3 basis points each for both the iShares and Schwab funds, both of which were recently reduced. That is a very, very low price to pay for access to--in all three cases--nearly the entire U.S. equity market. So, for a long-term investor that's looking for a well-diversified exposure to U.S. stocks at a rock-bottom cost, we think these funds are fantastic options, and all three have been awarded a Morningstar Analyst Rating of Gold.

Glaser: So, that's a good option there. Another area that there's been a lot of interest in on a slightly different note is high-yield bond. We've seen lot of flows into there, but you think the scenario that maybe indexing or ETFs is not necessarily the best choice.

Johnson: I think the high-yield space is a perfect case in point of some of the limits of indexing. So, by definition, high-yield bond ETFs have to track indexes that are somewhat less representative of the opportunity set that's available to their actively managed peers. These funds have to hold the most liquid, the largest issues in the high-yield bond space to be able to facilitate the type of liquidity that's required by the ETF wrapper. And by doing so they leave out really rich area of opportunity that has been exploited and will continue to be exploited by savvy high-yield bond managers that are managing active strategies to generate a liquidity premium.

So they're going into some hairier names, some things that might be less liquid, relative to the basket of bonds that is held by these high-yield bond ETFs. And by sacrificing that premium they're missing out on an area, an opportunity set where their active peers again have been able to make hay for quite some time. So, if you look at a high-yield bond ETF like the iShares iBoxx High Yield Corporate Bond ETF, the ticker for which is HYG, this inherently encumbered index that it tracks, stacks up neutral in our opinion. So, we've assigned it a Morningstar Analyst Rating of Neutral chiefly on the basis of what I've just described--that the underlying index isn't adequately representative of the opportunity set that's available to all of the players in that particular category.

Glaser: So this is an example where an ETF might be doing a good job of tracking its index, but you do think over time it will trail the rest of the category. And that's what this rating is really trying to get at.

Johnson: That'sexactly what we're signaling with our rating.

Glaser: So, another area that's been of interest both to a new ETFs coming out and also investor interest has been in the strategic-beta space. I know this is an enormous area, lot of different types of funds. But generally speaking do you think most of these are kind of on the medalist side or are you more skeptical of these strategies?

Johnson: So, there are a number of strategic-beta ETFs in that first 100 that we're rating, and we're taking a measured approach in our analysis, specifically as it pertains to analyzing the underlying processes as defined by their index methodologies. While many of these funds are tracking benchmarks that are fairly sensibly designed, that are trying to exploit well-known, well-documented factors, we're a bit cautious to the extent that in many cases, all we have to rely on in terms of historical performance, given the newness of these funds and the newness of their indexes, is a back-test. And there's no such thing as a bad-looking back-test and there is certainly no such thing as a fund that gets brought to market tracking an index that has a bad-looking back-test.

So, we're taking as I mentioned before a bit of a cautious approach in analyzing these, but also giving them the benefit of the doubt given that we think many of them are tracking, as I described before, soundly constructed benchmarks and giving them a bit more benefit of the doubt to the extent that their fees are oftentimes a fraction of those levied by their actively managed peers. So, a case in point here would be an ETF that we've talked about before, which is the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF, which we've assigned a Morningstar Analyst Rating of Bronze. So, Bronze being our lowest conviction positive rating reflecting the fact that we like the strategy, we like the way that the index is built, it's priced at 9 basis points, very competitively relative to its category, but it's only a year old. We don't have sufficient live track record to give us any higher degree of confidence in the merit of this strategy relative to its category peers.

Glaser: So, what's next for the rating? We have this first 100. What other areas do you want to bring under coverage?

Johnson: So, we'll continue to expand our rated universe of ETFs in the coming years. First and foremost, in terms of our our next wave of coverage, is we'll be expanding further into different fixed-income categories. So, fixed-income is somewhat less represented on this first wave of 100 funds that we're covering, we'll be in our next wave of coverage expanding in fairly dramatic fashion our coverage of fixed-income strategies.

Glaser: Ben, thanks for joining me today.

Johnson: Glad to be here, Jeremy.

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