The pitfalls of rating ETFs

Hortense Bioy

Hortense Bioy

On November 1 2017, Morningstar celebrated the first anniversary of its Analyst Ratings for exchange-traded funds (ETFs).

Over the past year, we have greatly expanded our coverage and we have now rated 463 ETFs worldwide, with aggregate assets under management (AUM) of around £2.1trn — accounting for nearly two-thirds of global ETF AUM.

In Europe, we’ve assigned analyst ratings to 153 ETFs, including 30 smart beta ETFs. 

Interestingly, it’s also been a year since the Financial Conduct Authority (FCA) published its Asset Management Market Study interim report, followed in June by the final report.

The study criticised ratings agencies and best buy lists for not making passive funds more visible and not highlighting all funds offering the best value for investors.

This twin anniversary provides me with a great opportunity to remind investors and their advisers that not all rating systems are equal, and that Morningstar takes a unique approach that directly addresses the FCA’s criticism. 

Most ratings for passive funds currently available to investors are tracking performance ratings. They aim to assess how well a fund tracks its underlying benchmark through the analysis of quantitative measures such as tracking difference and tracking error.

In some cases, qualitative analysis is also undertaken to form a view of the manager’s capabilities to execute their passive strategy effectively.

In my view, there are limitations to these purely passive ratings.

First and foremost, they are not “whole of market”. By that I mean that they don’t allow investors to compare passive funds with other options available to them, including active funds. This was one of the FCA’s critiques.

Also, these ratings are not very helpful when it comes to non-plain-vanilla passive market exposures.

Take the case of smart beta ETFs. It is fair to say that investors assessing a dividend ETF or a multi-factor ETF should care more about the merits of the underlying strategy than about how well the fund tracks its benchmark.

In that regard, smart-beta ETFs should be compared directly to active funds.

At Morningstar, we take a more holistic and qualitative approach to rating passive funds.

Tracking performance is certainly an input into our overall assessment of a passively-managed fund, but it is not what the rating represents.

The Morningstar Analyst Rating represents our assessment of a fund’s prospects relative to its category peers, which include both passive and active funds.

Comparing passive funds not just to other passive offerings makes perfect sense in a world where investors are becoming increasingly agnostic when it comes to investment style, active, passive, or smart beta and vehicle-type ETF or mutual fund. They are just looking to select best-of-breed strategies.