PDF Introducing the Morningstar Analyst Rating for Exchange ...

Introducing the Morningstar Analyst Rating for Exchange-Traded Funds

Morningstar Manager Research November 2016

Ben Johnson Director of Global ETF Research +1 312 384-4077 ben.johnson@

On Nov. 1, 2016, we unveiled Morningstar Analyst Ratings for more than 250 exchange-traded funds listed around the world. While this first batch of rated ETFs already accounts for a big portion of the global ETF market--over $1.75 trillion in assets worldwide as of the end of September--we expect to assign Analyst Ratings to dozens more ETFs in the months ahead.

Background The Analyst Rating--which follows a Gold, Silver, Bronze, Neutral, and Negative scale--is forwardlooking. It expresses our analysts' conviction in a fund's ability to beat its peers after accounting for fees and risk over a market cycle.

We've been assigning Analyst Ratings to mutual funds for about five years but with this launch we're extending the ratings to ETFs as well. (Note: We have also conducted qualitative, forward-looking analysis of ETFs for around eight years, but we had not assigned Analyst Ratings to ETFs until now.) Using the Analyst Rating, we believe investors can make sounder decisions about which ETFs to choose or avoid.

Because the Analyst Rating we assign to ETFs follows the same methodology that we use to assign ratings to traditional mutual funds, it should also make it easier for investors to compare ETFs against relevant mutual funds. That practice has grown more commonplace in recent years as ETFs have become more widely available and the popularity of low-cost, passive investing has taken hold.

A Rating with Purpose The purpose of Morningstar's qualitative, analyst-driven research on funds is to identify those funds that we believe should be able to outperform a relevant peer group, within the context of the level of risk taken, over a market cycle.

The pillars of our analysis are the same regardless of whether we are rating a passive ETF or an actively managed fund--those pillars being People, Process, Performance, Parent, and Price. However, their relative impact on our overall assessment of a fund differs somewhat when it comes to analyzing and rating ETFs.

Obviously, keeping costs--both explicit (the ETF's expense ratio) and implicit (that is, the cost of portfolio turnover)--at a minimum is paramount in the context of running an index-tracking fund. As such, it should come as no surprise that the top-rated ETFs that we analyze are not only among the

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Morningstar Analyst Rating for Exchange-Traded Funds November 2016

3 3 lowest-cost options in their Morningstar Categories when compared with their actively managed 3 peers, but also versus other passive funds.

Although costs are critical, they are just one component of our holistic assessment of ETFs. We also closely scrutinize an ETF's performance relative to peers in its Morningstar Category. And, as part of our Process Pillar assessment, we carefully analyze an ETF's underlying benchmark to understand how the portfolio is built and maintained as well as the techniques that the ETF's managers employ to track the index with precision.

Stewardship also plays a vital role in our analysis. We tend to favor parent firms that put investors' interests ahead of commercial goals and that align fund managers' incentives accordingly. Of course, the skills and experience of the people managing the ETF are an important factor in our analysis. In the management of ETFs, every 0.01% of performance counts, so it is vital to have a seasoned team in place. Thus, we evaluate these matters as part of the People Pillar assessment we conduct. In sum, we reserve our Morningstar Medalist ratings for those low-cost ETFs that we believe will tightly track a sensibly constructed index over a long time frame. We favor those ETFs backed by experienced managers and sponsored by firms that are good stewards of investors' capital. And we do so because we believe these attributes are likeliest to translate to outperformance when compared with a relevant peer group over a market cycle.

The Tally Of the 250-plus ETFs that we've rated across the globe, nearly three fourths are Morningstar Medalists. We have a positive view of these funds' prospects relative to their Morningstar Category peers. The positive skew largely reflects what we've chosen to cover. In deciding which funds to cover, we take into consideration funds' investment merit and investor interest. Thus, our first wave of rated funds represents some of the largest, most broadly diversified, and lowest-cost funds-- many of which are backed by top-rated stewards of fund shareholders' capital.

But indexing is not always a prudent strategy. This is particularly the case when ETFs and index funds fail to deliver on the key principles that have driven much of their success: low costs and broad diversification. Many of the funds in our initial rated universe fall short on one or both measures. This is reflected in the fact that just over one fourth of the funds in our initial rated universe have received a Neutral rating, while two funds have been rated Negative.

Exhibit 1 Distribution of Morningstar Analyst Ratings for Global ETFs

Rating

Number of Funds

%

OE

37

14

,,

80

31

?

74

28

68

26

?

2

1

Total

261

Source: Morningstar Direct. Data as of 10/31/2016.

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Morningstar Analyst Rating for Exchange-Traded Funds November 2016

3 3 Conclusion 3

Most investors do not have a black or white, active or passive view of the world. In fact, many are becoming increasingly strategy- and vehicle-agnostic, looking to select best-of-breed approaches to portfolio construction irrespective of where they are located on the active-to-passive continuum or whether they're a fund or ETF. They are simply looking to select the type of vehicle that best meets their needs. This is evidenced by the continued growth of assets under management in ETFs around the world.

We expect that these trends will only continue, and potentially accelerate over time, driven by a combination of investors' growing familiarity with the ETF wrapper, continued expansion of the menu of ETFs, as well as regulations such as the Department of Labor's fiduciary rule in the United States, the Retail Distribution Review in the United Kingdom, and the Future of Financial Advice in Australia. By incorporating ETFs into our Analyst Rating framework, we are leveling the field to help investors to pick the best funds from an ever-expanding list of choices. K

Additional Resources

Morningstar Analyst Rating for Funds Methodology Document:

Morningstar Analyst Rating for ETFs and Index Mutual Funds Methodology Document: for_ETFs_and_Index_Mutual_Funds.pdf

Morningstar Analyst Ratings for ETFs FAQ: external.pdf

Explainer Video: Morningstar Analyst Rating for Funds:

Explainer Video: Morningstar Rating for Funds:

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Morningstar Analyst Rating for Exchange-Traded Funds November 2016

3 3 Overview of Universe of Rated ETFs by Region and Morningstar Categories 3

Exhibit 2 Distribution of Morningstar Analyst Ratings for U.S.-Listed ETFs

Rating

Number of Funds

%

OE

18

18

,,

38

37

?

35

34

11

11

?

0

0

Total

102

Source: Morningstar Direct. Data as of 10/31/2016.

Exhibit 3 Distribution of Morningstar Analyst Ratings for U.S.-Listed ETFs by Morningstar Category

Morningstar Category

Morningstar Analyst Rating OE,,

Large Value Large Blend Foreign Large Blend Large Growth Mid-Cap Blend

Diversified Emerging Markets Europe Stock Mid-Cap Value Intermediate-Term Bond Small Blend

Small Value Mid-Cap Growth Short-Term Bond Small Growth World Stock

Corporate Bond Foreign Large Value Foreign Small/Mid Blend High Yield Bond Real Estate World Bond

Total

--

6

9

4

--

7

--

5

3

2

--

1

2

--

--

1

--

4

2

1

--

1

--

1

1

1

--

1

--

2

--

--

--

--

--

1

--

--

1

--

--

--

18

38

Source: Morningstar Direct. Data as of 10/31/2016.

?

8 2 2 2 1

3 1 3 -- 1

2 2 1 1 1

2 1 1 -- -- 1

35

?

2

--

--

--

--

--

--

--

--

--

1

--

2

--

1

--

--

--

--

--

1

--

--

--

--

--

1

--

--

--

--

--

1

--

--

--

2

--

--

--

--

--

11

0

Total

16 15 9 7 6

5 5 5 4 4

4 3 3 3 3

2 2 2 2 1 1

102

Page 5 of 16

Morningstar Analyst Rating for Exchange-Traded Funds November 2016

3

3 Exhibit 4 Morningstar Analyst Ratings for U.S.-Listed ETFs by Morningstar Category

3

Morningstar Category

Ticker

Morningstar Analyst Rating

Large Value Schwab US Large-Cap Value ETFTM Vanguard High Dividend Yield ETF Vanguard Mega Cap Value ETF Vanguard Value ETF Schwab US Dividend Equity ETFTM SPDR? S&P Dividend ETF WisdomTree LargeCap Dividend ETF iShares Edge MSCI USA Value Factor iShares Russell 1000 Value iShares S&P 500 Value PowerShares FTSE RAFI US 1000 ETF PowerShares S&P 500 Low Volatility ETF PowerShares S&P 500? High Div Low VolETF Schwab Fundamental US Large Company ETF WisdomTree High Dividend ETF SPDR? Dow Jones Industrial Average ETF

SCHV VYM MGV VTV SCHD SDY DLN VLUE IWD IVE PRF SPLV SPHD FNDX DHS DIA

,, ,, ,, ,, ,, ,, ? ? ? ? ? ? ? ?

Large Blend Schwab US Broad Market ETFTM Schwab US Large-Cap ETFTM SPDR? S&P 500 ETF Vanguard 500 ETF Vanguard Large-Cap ETF Vanguard Total Stock Market ETF Vanguard Dividend Appreciation ETF iShares Core S&P 500 iShares Core S&P Total US Stock Mkt iShares Edge MSCI Min Vol USA iShares Russell 1000 iShares Russell 3000 Vanguard Mega Cap ETF OEman Sachs ActiveBeta? US LgCp Eq ETF PowerShares S&P 500? Quality ETF

SCHB SCHX SPY VOO VV VTI VIG IVV ITOT USMV IWB IWV MGC GSLC SPHQ

OE OE OE OE OE OE OE OE OE ,, ,, ,, ,, ? ?

Foreign Large Blend iShares Core MSCI EAFE iShares Core MSCI Total Intl Stk iShares Edge MSCI Min Vol EAFE Schwab International Equity ETFTM Vanguard FTSE All-World ex-US ETF Vanguard Total International Stock ETF Vanguard FTSE Developed Markets ETF iShares MSCI ACWI ex US iShares MSCI EAFE

IEFA IXUS EFAV SCHF VEU VXUS VEA ACWX EFA

,, ,, ,, ,, ,,

,, ,, ? ?

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