These 3 ETFs Are Top Options in Their Categories

Our new Morningstar Analyst Rating for exchange-traded funds helps investors more easily compare mutual funds with ETFs to find the investment that best fits their needs.

As Morningstar director of global ETF research Ben Johnson explained in a recent video, investors have increasingly become "vehicle-agnostic" as their opportunity set has expanded. This means that investors in search of a specific type of fund are probably not looking strictly at active strategies or passive ones--likely, they are considering both types, and selecting the fund that works best in the context of their portfolio.

Because the ratings we assign to ETFs follow the same "five pillars" methodology we use to assign ratings to traditional mutual funds, investors can now easily compare ETFs with mutual funds plying the same investment strategy. So if an ETF earns a Gold rating, we expect that over time and accounting for fees and risk, it will outperform lower-rated ETFs and open-end mutual funds in that category.

Below we highlight three passive ETFs in categories where one might intuitively think active management has an edge, but where we think an ETF actually has a good chance of outrunning peers. (As Morningstar director of passive strategies research North America Alex Bryan pointed out in this article, many areas of the market that are perceived to be less-efficient are actually fairly competitive, giving indexing good odds of outperforming.) And ETFs often have lower costs of ownership than traditional mutual funds, giving ETFs some advantages right out of the gate.

On the flip side, we also highlight a popular ETF that we believe is inferior to highly rated actively managed peers in the same category, as we feel active managers are better positioned to take advantage of this particular category's opportunity set.

Vanguard REIT ETF

VNQ

Morningstar Analyst Rating: Gold Morningstar Category: Real Estate Price: 0.12%

VNQ tracks the MSCI US REIT Index, which provides exposure to equity REITs, or firms that manage properties and collect rent. It is a more traditional, core real estate portfolio because the index doesn't provide exposure to mortgage REITs, which invest in mortgages and mortgage-backed securities rather than actual properties, and non-real-estate specialty REITs such as timber or cell-tower REITs.

The ETF has a very experienced manager in Gerard O'Reilly, who has managed the mutual fund version of this strategy since 1996. O'Reilly has also run

There are some risks facing the portfolio, however. Kathman notes that this fund has significant exposure to the REITs with longer lease durations, which would be expected to get hit hardest during a period of rising interest rates. But he also notes that REIT subsectors with longer lease durations, such as healthcare REITs, offer investors a greater margin of safety (in terms of valuation) at present. Kathman also points out that rates don't rise in a vacuum; historic evidence demonstrates that economic growth (which often corresponds with rising rates) is a key driver of REIT performance.

Overall, VNQ features experienced management and an excellent record of tracking its index, all of which makes it a fine option for investors seeking exposure to the real estate sector, in Kathman's opinion.

iShares Core S&P Small-Cap

IJR

Morningstar Analyst Rating: Gold Morningstar Category: Small Blend Price: 0.07%

IJR ventures down to lower rungs of the market-cap ladder than many of its category peers do. Stocks must have a market cap between $400 million and $1.8 billion to be included in the index, and the ETF's $1.5 billion average market cap is half of the category average, says Morningstar analyst Adam McCullough. Further, micro-cap stocks represent more than a third of IJR's holdings, compared with less than 5% for the category average.

It's also more diversified than peers: Its top 10 holdings represent only 5% of assets, compared with the small-blend Morningstar Category average of 22%, says McCullough.

Investing in small caps sometimes comes with liquidity challenges; the index uses liquidity screens, which help ensure that the strategy can handle the liquidity demanded by the ETF wrapper. But it also applies a profitability screen, which screens out recent IPOs and companies that are not financially viable. Despite its lower average market cap, the fund has a higher return on equity than peer market-cap-weighted funds, McCullough notes. (Research by AQR and others suggests that though small-cap stocks have a demonstrated historic return premium, they also tend to be riskier and less profitable than larger caps. Therefore, the addition of a profitability screen may improve the size premium's efficacy.)

Overall, IJR's efficient index construction and profitability tilt have paid off. For the trailing 10 years through October 2016, it has bested the category average by 1.5 percentage points per year with slightly less volatility as measured by standard deviation.

iShares Core MSCI Europe

IEUR

Morningstar Analyst Rating: Gold Morningstar Category: Europe Stock Price: 0.10%

IEUR offers broad, diversified exposure to stocks listed in developed European countries, representing the largest 99% of the investable market. It weights these stocks by market capitalization, which promotes low turnover, says Morningstar's Alex Bryan.

Though Bryan concedes that uncertainty surrounding "Brexit" could potentially weigh on the fund's holdings, European stocks could be priced to offer competitive compensation for their risks, he says. He also points out that as of the end of September the fund's holdings were trading at lower valuations than their U.S. counterparts based on price/forward earnings, and they offered a higher average estimated dividend yield.

In addition, Bryan notes that the European Central Bank has pursued aggressive monetary policy to keep interest rates ultralow and stimulate demand, and rates are likely to remain low in the near term.

All told, IEUR tracks a broadly diversified, well-constructed index, in Bryan's opinion, and it's one of the cheapest funds in the Europe-stock Morningstar Category.

SPDR Barclays High Yield Bond ETF

JNK

Morningstar Analyst Rating: Neutral Morningstar Category: High Yield Bond Price: 0.40%

JNK's low price tag is one point in its favor; in fact, it's one of the cheapest high-yield strategies across ETFs and high-yield mutual funds. However, we believe that the high-yield bond market is an area where experienced active managers can add value over passive vehicles. For that reason, this ETF earns a Morningstar Analyst Rating of Neutral.

JNK attempts to track the Barclays High Yield Very Liquid Index, which includes only bonds with $500 million or more of outstanding face value. This size restriction helps to manage liquidity risk by avoiding smaller and thus typically less-liquid bonds, but it does so at the opportunity cost of forgoing the higher yields those smaller bonds typically provide. (However, despite its liquidity parameters, this fund does not eschew risk completely; Morningstar analysts point out that as of mid-October 2016, JNK held a higher weighting in bonds rated CCC or below than the the widely followed broad market BofAML U.S. High Yield Master II Index.)

We believe this opportunity cost should not be underestimated. Experienced active high-yield bond managers can use smaller bonds tactically to generate extra yield and can also add value over standard benchmarks by adjusting sector and individual bond positioning based on expected changes to the underlying issuer's fundamentals. Over the trailing five-year period ended Oct. 31, 2016, JNK's 5.1% annualized return lags its benchmark's 6.5% return and the 5.9% average return for Morningstar's open-end high-yield bond category.

Investors seeking open-end alternatives might consider actively managed

Click here to see the full list of initially rated U.S.-listed exchange-traded funds.