Michael Krause, President of AltaVista Independent Research, has an excellent exchange traded fund (ETF) service.  Recently he came out with some opinions regarding the evaluation of ETFs.  He raises some good questions and makes some points including:

  1. ETFs are evaluated like Mutual Funds, but that is a problem
  2. Need to use forward-looking measurements, like fundamentals
  3. ETF fees are irrelevant

ETFs: A Fundamentally Different Approach
Why the Warmed-Over Mutual Fund Approach is the Wrong Approach

by Michael Krause
President, AltaVista Independent Research
January 22, 2007.

When the world’s first exchange traded fund, the S&P 500 SPDR, was listed over a decade ago, things were simpler. People were broadly familiar with the S&P 500 index, and assuming an investor had already decided to try to track the index, explaining the advantages and disadvantages of the ETF structure versus that of a comparable index mutual fund was sufficient as far as ETF analysis was concerned.

Since then, however, the number of ETFs available to investors has exploded. The array of over 400 choices and the flexibility it brings is positive, but it also complicates the selection process. How do I know which ETF make the most sense for my portfolio?

Perhaps because ETFs started out being compared to mutual funds, as they grew in number most analysts started evaluating them as mutual funds. Morningstar™, for example, the large mutual fund rating outfit, says in materials on its website, “The Morningstar Rating for exchange-traded funds uses the same methodology as the Morningstar Rating for [mutual]funds.”

Therein lies the problem. Mutual funds are typically evaluated based on past performance and fees.
That’s appropriate for most mutual funds, which are actively managed, because what you are really doing is hiring a manager to invest on your behalf. Therefore it makes sense to ask how well the manager has done this in the past, and how much the fund charges for his or her services.

But with ETFs it’s different. There is no active manager deciding when to buy or sell certain stocks; no one, for example, deciding when to lighten up on a certain sector or when to increase exposure to a certain market cap segment. There is nothing inherently good or bad about a particular index that an ETF tracks. Rather, the investment merit of an ETF is determined by two factors: market conditions, and the fundamentals of the underlying stocks which comprise the fund. These, of course, change all the time.

This difference is like night and day; it is one being backwards-looking versus forward-looking. Who is not aware that, over the past five years, Technology stocks in general were a bad investment? What moderately-informed investor doesn’t already know that over the same time period small cap stocks outpaced large cap stocks? If a mutual fund manager failed to foresee changes in the economy and in the market, and stayed overexposed to large cap Tech stocks, you’d have a valid complaint that he was probably not earning his keep. But an ETF tracking an index of Tech stocks, or an index of large cap stocks, didn’t change its portfolio because it isn’t supposed to—it is just supposed to track the index.

However, concluding that, based on past performance a Technology ETF is therefore a bad investment going forward, or that a small-cap ETF is therefore a good investment, is absurd. Tech stocks were a bad investment, and small caps were a good investment, but that tells you next to nothing about how they are likely to perform in the future. And besides, unlike a mutual fund you can short an ETF, so even a bad investment, correctly identified, can be turned into a good thing.

So, how do we intend to divine any forward-looking measurements of an ETFs investment merit? Fortunately, we have a set of existing tools that can help. One of the least-recognized but important advantages of an ETF is that they are transparent. Unlike a mutual fund, the holdings of an ETF, and their weight in the index, can be known at any point in time, As a result, it is possible to marry the list of constituents with all the fundamental data available about those constituents to create a very informative picture of the basket as a whole. One can find the answer to important questions such as:

• Which ETFs offer the best earnings growth? The best dividend yields?
• Which are seeing estimates raised, and where are they getting slashed?
• Which show trouble brewing on the balance sheet?
• How is it valued, relative to expectations and relative to other ETFs?

Knowing such information is extremely helpful because it is forward looking. You can use this information either to compare ETFs across categories or within categories. Financial advisors often develop an asset allocation plan based on the goals, risks tolerances, and time horizons of their clients, and then try to select an investment to represent each asset class. But when using ETFs to accomplish this, too often they have to make a leap of faith as to which ETF is the best bet within the asset class, based on little or no information.