As adaptation and proliferation of alternatively-indexed or strategic beta exchange traded funds increases, advisors and investors are scouring for new ways to evaluate these ETFs.
One evaluation tool for strategic beta ETFs, though it should be the sole determinant of a fund’s merits, is the well-known Morningstar rating, which uses stars with five stars being the most prestigious. Investors that have been involved with active mutual funds are likely familiar with Morningstar ratings. The issuers of those funds are not shy about bragging about their Morningstar ratings and the managers of those funds are not shy about chasing those ratings.
Hence, mutual funds with four- or five-star ratings from Morningstar are often prodigious accumulators of investor assets. Although the terms alternative indexing, smart beta and strategic beta are relatively new buzzwords, many of the ETFs to which those terms apply have seasoned track records, but as Morningstar notes, its ratings for strategic beta ETFs and mutual funds differ. [Smart Beta ETFs Gain Critics, Fans]
“The star rating is based on a ranking of the Morningstar Risk-Adjusted Return. This starts with the Morningstar Return, which is the load-adjusted return in excess of the risk-free rate. ETFs benefit because they do not charge loads while many retail share classes of mutual funds do. ETFs also benefit from lower expense ratios, which is one of the biggest determinants of relative performance,” said Morningstar analyst Michael Rawson in a recent research note.
Rawson also points out that the while just 29% of 6,088 share classes of 1,811 U.S. equity mutual funds had four- or five-star ratings. On the other hand, “strategic-beta ETF ratings do not have to follow a bell curve, and indeed they do not, as 63% of the 51 non-strategic-beta U.S. equity ETFs and 76% of the 92 strategic-beta U.S. equity ETFs have 4- or 5-star ratings.”
Highly-rated strategic beta ETFs by Morningstar include some familiar, seasoned names. For example, the PowerShares S&P 500 High Quality Portfolio (NYSEArca: SPHQ), one of the first ETFs to focus on the quality factor, carries a four-star rating from Morningstar.
SPHQ tracks the S&P 500 High Quality Rankings Index, which “is designed to provide exposure to the constituents of the S&P 500 Index that are identified as stocks reflecting long-term growth and stability of a company’s earnings and dividends,” according to PowerShares. The $403.2 million SPHQ will turn nine in December. [A High Quality ETF]
Some popular dividend ETFs also carry high Morningstar ratings, including the $1.2 billion WisdomTree Dividend ex-Financials Fund (NYSEArca: DTN), which is a four-star ETF.
As its name implies, DTN excludes the financial services sector from its lineup. Although that sector has rebound from the dark days of 2008 and has gotten back to dividend growth over the past several years, DTN has not been hindered by excluding bank stocks. Since the March 2009 market bottom, DTN has returned nearly 314% while the best performance among the four largest U.S. dividend ETFs over that period has been a 256.3% gain.
Investors can also find highly-rated strategic beta sector ETFs as four of First Trust’s nine AlphaDEX sector ETFs carry five-star ratings from Morningstar. That group includes the $1.38 billion First Trust Consumer Staples AlphaDEX Fund (NYSEArca: FXG) and the $889.5 million First Trust Financial AlphaDEX Fund (NYSEArca: FXO), two ETFs that are among this year’s top performers from their respective sectors.
“While past performance may not tell you everything you need to know, it can be a useful data point among others in a more comprehensive analysis. In contrast to the historical performance rating, the Morningstar Analyst Rating is based on a five-pillar framework that evaluates a fund’s prospects. These pillars include Price, People, Parent, Process, and Performance. Investors should evaluate the suitability of a fund in the context of their portfolio and their investing objectives,” adds Morningstar.
WisdomTree Dividend ex-Financials Fund
Tom Lydon’s clients own shares of DTN.