Learn more about our enhanced ETF Analyst Reports and data.
By Jeffrey Ptak, CFA | 02-27-08 | 06:00 AM | Email Article

We recently made a number of exciting enhancements to our ETF research. For instance, we've retooled the content and format of our ETF Analyst Reports. In addition, we've introduced a host of innovative data points, such as the new valuation rating for ETFs, that add granularity and context to our research. (Click here for an overview of these changes, here for a more-detailed walk-through, and here for a sample ETF Analyst Report.)

Jeffrey Ptak, CFA, is head of global manager research for Morningstar.

To help you learn more about our new ETF reports and data, we've prepared the following Q&A for your reference. Following are answers to a short-list of questions that might arise regarding the changes we've made to our ETF research.

If you have other questions that I haven't addressed below, or simply want to give me feedback about our ETF research, drop me a line at jeffrey.ptak@morningstar.com. I'll get back to you as soon as I can.


Overview of Changes

ETF Ratings

ETF Coverage

What changes are you making to your ETF research?
We're expanding the focus of our coverage to now include stock ETFs' merits from a valuation standpoint. We're leveraging our in-house equity research covering more than 2,000 stocks to estimate an ETF's intrinsic worth based on the fair value estimates our stock analysts have placed on its underlying stock holdings.

As part of this enhancement, we've reformatted our ETF Analyst Reports and introduced new proprietary data points, including a "valuation rating" that denotes whether an ETF is a bargain or not by comparing its market price with our estimate of its intrinsic worth.

We will continue to provide research that's geared toward investors who are using ETFs as portfolio building blocks. That research, which remains just as relevant today as it was before we undertook these enhancements, generally focuses on factors such as expenses, portfolio construction, tax efficiency, and performance.

Why are you changing your ETF research?
ETFs are versatile products that support a multitude of uses. For instance, some investors might use ETFs as simple, no-fuss, low-cost building blocks for a portfolio that they rebalance occasionally but otherwise don't tinker with. Others might employ them as alternatives to positions in single stocks. For instance, rather than own a single stock in the oil patch, these investors might opt for an ETF that affords one-stop exposure to a number of different energy-related firms.

The point is that ETF usage is diverse and evolving. Thus, we've made these enhancements to address a broader range of needs. For instance, we think investors using ETFs to invest opportunistically in certain segments of the market--i.e., as alternatives to positions in single stocks--will find our new valuation ratings quite useful. Thus, although we will continue to support the needs of investors who use ETFs primarily as portfolio building blocks, we're broadening the scope of our research to appeal to other types of investors as well.

Does the new "valuation rating" take the place of the Morningstar Rating for ETFs?
No. The Morningstar Rating for ETFs--that, is, the star rating--will remain for the foreseeable future. The new valuation rating will complement the star rating.

What's the difference between the star rating and the new valuation rating?
The star rating is based on a wholly quantitative rating system that uses trailing risk-adjusted return data to rank ETFs of the same type. It is backward-looking. You can use the star rating as a starting point in your research to judge ETFs' past performance versus category peers.

The valuation rating is based on a qualitative system that rates a stock ETF by comparing its market price with our stock analysts' estimate of its fair value. It is forward-looking. You can use the valuation rating to identify ETFs that are mispriced--undervalued or overvalued--and capitalize on those opportunities.

How does the valuation rating work?
The valuation rating compares a stock ETF's market price with our stock analysts' estimate of its fair value.

An ETF's fair value estimate is based on the fair value estimates that our analysts have placed on an equity ETF's underlying stock holdings. By aggregating these fair value estimates, we can estimate the fair value of the ETF as a whole.

Because these fair value estimates are based on our analysts' forecasts of the future cash flows that each firm is expected to generate, they are forward-looking.

When an ETF trades at a meaningful discount to our fair value estimate, we'll rate it "undervalued," and when it trades at a significant premium to our estimate of its intrinsic worth, we'll rate it "overvalued."

Why two ratings?
The star rating and valuation rating address distinct needs.

Some investors are primarily interested in evaluating ETFs as potential portfolio building blocks. Their research is likely to consider factors such as an ETF's past performance. The star rating can be a useful starting point for such research insofar as it helps investors assessing an ETF's past performance compared with similar funds.

Other investors are primarily interested in using ETFs to invest opportunistically in particular market segments. The valuation rating is useful in that regard, as it denotes which ETFs are fundamentally undervalued, overvalued, or fairly valued in our analysts' estimation. In that way, it helps investors to spot promising ETF investment opportunities as they arise.

You're recommending a lot of ETFs that your analysts didn't applaud in the past. Why the change of heart?
In the past, our analysts evaluated ETFs with the needs of "portfolio-builders" chiefly in mind. These are investors who are using ETFs to anchor, or complement, a long-term strategic portfolio allocation. As such, our research revolved around attributes such as cost, portfolio construction, tax efficiency, and past performance. Low-cost ETFs that were founded on prudent, tax-efficient strategies usually earned our recommendation. ETFs that fell short on any of these counts did not.

Our new ETF "valuation ratings" assess stock ETFs under an entirely different framework. We're comparing a stock ETF's market price against our analysts' estimate of its intrinsic worth. Although cost matters insofar as it's an additional hurdle an ETF must clear, it doesn't govern our ratings. That is, if an ETF looks undervalued when we compare its market price to what we think it's worth, yet levies a higher expense ratio than comparable alternatives, we'll still rate it "undervalued." Similarly, while we consider many ETF strategies gimmicky, it's possible that some of these portfolios will consist of cheap stocks. We won't hesitate to recommend such ETFs on a valuation basis.

How many stock ETFs will you calculate fair value estimates for?
We will estimate a stock ETF's fair value only when our analysts cover a large portion of the fund's portfolio. Our threshold is 70% of fund assets. When our analysts cover stocks accounting for 70% or more of a fund's assets, we'll estimate that ETF's fair value.

As of Feb. 14, 2008, we were calculating fair value estimates for more than 300 stock ETFs.

If you calculate an ETF's fair value estimate, will you also provide a valuation rating?
Frequently, but not always.

We provide "valuation ratings" only for stock ETFs that our ETF analysts have evaluated. As mentioned above, we can estimate an ETF's fair value by simply aggregating the fair value estimates they have placed on the fund's underlying stock holdings. Provided that we have adequate coverage of a stock ETF's holdings (our threshold is 70% of fund assets), this is a relatively straightforward arithmetic exercise.

However, before we can provide a valuation rating, our ETF analysts must assess the ETF's risk and assign it to a particular risk cohort.

Why does risk matter? The riskier an ETF, the wider the "margin of safety" we would demand before recommending the fund, and vice versa. A "margin of safety" refers to the discount to fair value that we'd need to see before we'd consider an ETF "undervalued." By assigning a risk cohort to each ETF they cover, our ETF analysts determine the magnitude of that discount and, thus, facilitate the rating process. Absent that assessment, we can't, and won't, provide a valuation rating.

Anytime our ETF analysts assess an ETF's risk, they author an Analyst Report. So, if our analysts haven't written a report on a particular stock ETF, it won't carry a valuation rating, even if we're able to calculate a fair value estimate for the fund.

What if your analysts don't cover many of an ETF's holdings--for instance, foreign stock ETFs, small-cap stock ETFs, bond ETFs, and commodity ETFs?
Our analysts cover a significant number of foreign stocks. As such, we are able to calculate fair value estimates for a number of foreign-stock ETFs, although these generally tend to be funds that hold large-cap names, ADRs in particular. As we continue to expand our coverage of foreign stocks, we will be able to calculate fair value estimates for a broader swath of foreign equity ETFs.

Although our analysts cover more than 2,000 stocks, many of these are large- and mid-cap names. Our coverage of the small-cap universe is less comprehensive. As of Feb. 14, 2008, we covered stocks accounting for roughly 50% of the major U.S. small-cap indexes. Since that coverage falls shy of the 70% threshold, we will not calculate fair value estimates for most small-cap ETFs. Our analysis of these funds will typically be a hybrid of valuation-centric research (for instance, what does our equity research imply about the stocks in the portfolio that we do cover) and research geared toward portfolio-builders (for example, Is the fund cheap? Founded on a prudent strategy? Tax-efficient?).

Because we do not analyze individual fixed-income securities or commodities, we will not calculate a fair value estimate for any bond or commodity ETFs. Instead, we will analyze these ETFs to determine their merits as portfolio building blocks. That analysis will continue to focus on attributes such as cost, portfolio construction, tax efficiency, and performance.

You've made a number of changes to the list of ETFs you cover. Why?
That's correct. We've increased the number of sector, country-specific, bond, and commodity ETFs that we cover.

Although there is no set formula, we generally try to ensure that we're covering ETFs that represent a large chunk of industry assets and trading volume. In that way, we're reaching the widest possible spectrum of investors and providing research that's broadly responsive to their needs.

That desire informed some of the recent changes we've made to our coverage universe. Sector- and region-specific stock ETFs represent a large and growing segment of the ETF marketplace. We've ratcheted up our coverage of those types of ETFs, accordingly.

By the same token, we will always try to shine a light on investment opportunities that we consider especially compelling (or odious). Thus, we will continue to cover ETFs that, while small or lightly traded, we think warrant investors' attention (or caution)--for instance, a new ETF that's particularly useful in a portfolio context, or a relatively obscure stock ETF whose holdings happen to be grossly undervalued.

Do you plan to cover more ETFs in the future?
Yes. We plan to expand our ETF coverage universe in the coming months.

That said, it's worth nothing that we are calculating fair value estimates for more than 300 stock ETFs. Although our ETF analysts don't cover all of these funds, these fair value estimates should give investors important insights into the attractiveness of an ETF's valuation. Thus, in a sense, we've roughly doubled our coverage universe already, with further expansion to come.

Securities mentioned in this article



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Jeffrey Ptak, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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