Beginning this past month, Morningstar changed their star methodology to combine the ETF and Mutual Fund universes into a single universe for ranking purposes.
This was due in part to the continued usage of ETFs in investor portfolios, taking the place of their mutual fund brethren in an allocation. The blurring of the line separating ETFs and Mutual funds (i.e. via the continued innovation in alternative-weighted ETFs) has contributed to this trend.
While the merits of star ranking can be a topic of debate, the combining of these universes for ranking purposes allows for yet another side-by-side comparison tool for investors contemplating replacing a mutual fund allocation with an ETF allocation (or vice versa, although this does not seem to be the trend based on flow data). While stars should definitely not be the sole reason an investor switches from one fund to another, they can be one input in the decision making process.
The first note that needs to be made regarding stars is that a fund or ETF must have a minimum of a three-year track record. Additionally, not every category is rated (i.e. leveraged/inverse ETFs, volatility ETFs). What this leads to is over half of the ETF universe not having a star ranking (this compares to about 20% of the mutual fund universe, limiting by oldest share class per fund). Additionally, as a fund matures, less of its star ranking is dependent on shorter-term performance. Therefore, those funds/ETFs that have a shorter performance track record will have its ranking purely based on short-term performance.
Now that the universes are combined, a logical question could be in which market segments do ETFs rank higher and which categories do mutual funds rank better? In the following, I will compare and contrast different categories.
First, I will look at which categories have at least one ETF with a five-star ranking with the mutual funds having none, of which there are five categories:
| Category | Count |
| US Fund Consumer Defensive | 3 |
| US Fund Convertibles | 1 |
| US Fund Industrials | 3 |
| US Fund Latin America Stock | 2 |
| US Fund Utilities | 2 |
Digging in a bit, a couple themes with these names stick out. First, in industrials, all the names are Aerospace and Defense ETFs as that industry has performed well. Second, within the two other (defensive) sector categories above, they are represented by both equal weight and smallcap sector names. Therefore, while not an across-the-board phenomenon in terms of sectors, smaller cap defensive names have risen in the ranks.
Conversely, there are 60 different categories where at least one fund has a five-star ranking with no ETFs as such. This brings us to one significant difference in that there are many fund categories where ETFs are sparsely represented, with some examples being municipal bond and allocation funds (i.e. target date funds). Here is a subset of categories that do not have a five-star rated ETF (limiting to those categories that have at least ten ratable ETFs):
| · US Fund Commodities Broad Basket |
| · US Fund Corporate Bond |
| · US Fund Diversified Emerging Mkts |
| · US Fund Equity Precious Metals |
| · US Fund Foreign Large Value |
| · US Fund India Equity |
| · US Fund Inflation-Protected Bond |
| · US Fund Intermediate-Term Bond |
| · US Fund Mid-Cap Growth |
| · US Fund Pacific/Asia ex-Japan Stk |
| · US Fund World Stock |
The differences here can be twofold. One may be that the active management available in mutual funds in these categories still outweighs the benefits of ETFs. Second, for those ETFs being rated off short-term performance only versus funds that may have a longer-term track record off which the rating is based, the market environment can play a key role in determining the differences.
A secondary view of this would be to compare the percentage of ratable ETFs in a category that have five stars as compared to the percentage of mutual funds. This standardizes the analysis to compare only the different options with a long enough track record. Here are the top five categories where the percentage of ratable ETFs with five stars is the greatest versus mutual funds:
| · US Fund Convertibles |
| · US Fund Large Growth |
| · US Fund Consumer Defensive |
| · US Fund Emerging-Markets Local-Currency Bond |
| · US Fund Large Value |
While there are a couple more esoteric categories, ETFs have a higher percentage in two very broad categories in Large Growth and Large Value. Digging a bit into the data, the Large Growth appears to be a function of the ratio of Nasdaq-based ETFs, while on the Value side, the ETF ranks are dominated by Dividend ETFs.
Here is the same look with the categories where percentage of ratable mutual funds is the greatest (again with the same filter on the ETF universe of at least 10 ratable ETFs).
| · US Fund Inflation-Protected Bond |
| · US Fund Pacific/Asia ex-Japan Stk |
| · US Fund India Equity |
| · US Fund Foreign Large Value |
| · US Fund Diversified Emerging Mkts |
The first theme that sticks out here is the dominance of non-US categories in which mutual funds rank higher. Similar to the ETF comparison, there are a couple broader categories that funds rate better on in Foreign Large Value and Emerging Markets. As I mentioned before, this could be a function of both active management outperforming passive management and/or the market environment in which the funds are being rated on (i.e. ETFs rated on a short-term view versus their mutual fund counterparts).
As I mentioned before, star ratings are only one of many inputs that can be utilized to compare ETFs versus mutual funds. After looking at the two universes, it appears that there are some categories in which ETFs are leading and some in which they are lagging. However, as the ETF universe continues to evolve and, more importantly for this analysis, mature, the line separating the two universes may continue to blur. Morningstar has reinforced this by combining the universes, now time may be next catalyst.
Clayton Fresk is a Portfolio Manager at Stadion Money Management, a participant in the ETF Strategist Channel.
Disclosure
Past performance is no guarantee of future results. Investments are subject to risk and any investment strategy may lose money. The investment strategies presented are not appropriate for every investor and financial advisors should review the terms and conditions and risks involved. Some information contained herein was prepared by or obtained from sources that Stadion believes to be reliable. There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change. Any references to specific securities or market indexes are for informational purposes only. They are not intended as specific investment advice and should not be relied on for making investment decisions. One cannot invest directly in indexes, which are unmanaged and do not incur fees or charges. Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com. SMM-122016-936