These 2 Large-Cap ETFs Fall Short

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Morningstar launched ratings for exchange-traded funds this fall. Joining me to discuss some characteristics of less-than-stellar index funds and ETFs is Ben Johnson, he's director of global ETF research with Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Glad to be here, Christine.

Benz: Ben, before we get into characteristics of less-than-stellar index funds and ETFs, let's start by talking about the ratings for ETFs, they launched this fall. Let's talk about what you and the team are looking for when you award ratings to funds.

Johnson: When we rate ETFs, we apply the same framework that we've been applying in rating and assigning Morningstar Analyst Ratings to actively managed mutual funds now for over five years. So, there are five pillars that underpin our Morningstar Analyst Ratings. Those are Process, People, Price, Performance, and Parent. When looking at ETFs there are two of those five pillars that really move the needle on our overall assessment and those are Process and Price. So, when we look specifically at Process, we want to ask two big picture questions. First and foremost, how is the index underlying this particular fund built; what are the details of its methodology; and what would we expect on the basis of that input, that methodology, in terms of an output with regard to the risk and return profile of the resulting portfolio. So, we tend to favor indexes that will result in portfolios that are very broadly diversified and very representative of the particular asset class or the particular strategy that they are setting out to represent. Secondly we ask with respect to Process, how is the portfolio actually managed to track that benchmark? Is it built in a way that is going to deliver high fidelity tracking of that index? These are index funds after all, we want them to track that bogey. 

Now I mentioned Price is the other crucial input into our rating. What we know about fees is that fees matter, fees matter perhaps more than anything, certainly more than most other things. The less that we pay the more that we get. Most ETFs, most index funds, have a sizable advantage relative to their active peers in particular, to the extent that they tend to charge much lower fees.

Benz: So, let's get into the Process piece and talk about some situations, some index funds or ETFs where you might look at the index that, that product is tracking and say, that's a less-than-ideal construction. Let's talk about how you and the team might arrive at such a conclusion.

Johnson: So, common characteristics of a less-than-ideal index are that it fails on one of a number of measures. So, narrowness for example, excessive concentration fails the diversification test and oftentimes the representativeness test. So, certain indexes are built in such a way that they reflect a very fine slice of a market or they might be overly concentrated at the level of an individual security or at the level of individual sector or country. So, if you look at legacy exchange benchmarks, for example, something like the NASDAQ or overseas exchange benchmarks like the DAX in Germany, the perfect case in point--the one that’s actually assigned to an ETF that we've assigned a Neutral rating to--would be Dow Jones Industrial Average. So if you look at the SPDR Dow Jones Industrial Average ETF, the ticker for which is DIA, we have given that fund a Neutral rating chiefly on the basis of their or our assessment rather of the Dow Jones Industrial Average Index, which was first conceived and calculated in the 1897.

At that point in time it made sense to, given the lack of computing power really, weight stocks in that portfolio on the basis of their price. So the biggest stock by way of its share price is the biggest stock in that portfolio. There is no real intuition there. It was done out of necessity, and what we see is a portfolio of stocks that is decided upon by a committee. So there is an element of judgment there, that is weighted on the basis of their price, which lacks any real intuition, that is interesting in terms of the Dow's up, the Dow's down on any given day, if you are reading it in the newspaper. But isn't really compelling in terms of an investment proposition. There is no economic intuition there.

Benz: Another example that you want to talk about that you think illustrates what you and the team are looking for or not looking for--where you are looking at an issue with the Process as well as the Price. Let's talk about that one.

Johnson: PowerShares Dynamic Large Cap Value ETF, the ticker for which is PWV, is an example of an ETF that falls short on both its Process as well as its Price. So what you see here is an example of an underlying index that is unnecessarily overwrought. The methodology is convoluted. It smacks at being the product of a lot of back-testing. The result is a portfolio that is fairly concentrated, which again fails that broad diversified test. It also has a high degree of turnover which is also not often a characteristic of index funds. And it charges a premium price. So our overall rating for this particular fund is Neutral on exactly those two counts of falling short with respect to its Process as well as its Price.

Benz: What would be an example of a large-cap value fund that you and the team like more?

Johnson: So if you look at the Vanguard Value ETF, for example, what you see is a very broadly diversified portfolio, that tilts toward value stocks at a very, very low fee. Not only relative to its category peers at large but also relative to other index fund and ETF options within that particular category. It's very broadly diversified, representative of the strategy in question and priced in a way that is extremely competitive.

Benz: OK, Ben I know that a lot of our users have been really looking forward to these ratings. Thanks for being here to discuss them with us.

Johnson: Happy to be here.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.