Thursday, March 30, 2006

Morningstar ETF Star Ratings

Recently Morningstar has come out with star ratings for Exchange Traded Funds. Greg Newton and Roger Nusbaum submitted articles to Seeking Alpha critiquing the idea and worth of these ratings. Broadly, I agree with Greg and Roger.

The whole concept of star ratings for ETF's is absurd. ETF’s are passive investments. The ETF sponsor cannot affect its performance in any way. The only thing that can influence an ETF’s performance is the performance of the underlying index. And past performance does not predict future results.

A simple example is the Select Sector SPDRs that cut up the S&P 500 into nine sectors. Morningstar has given the Materials SPDRs four stars while giving the Health Care SPDR two stars, based on past performance over the last three years. The reason for relative disparity between the performance of XLB and XLV has everything to do with the past performance of materials vs. healthcare, and nothing to do with the ETF's themselves. There is no ab initio reason for believing that XLB will continue to outperform XLV. And thus there is no reason for giving XLB or any fund other any number of stars.

At the moment most ETF’s are based on “benchmark” indexes that are designed to cover a certain market segment. One of the advantages of that has been the rise of very fine grained ETF's like the Palisades Water Index (PHO) or KBW Capital Markets (KCE). Only a few ETF’s are explicitly designed to beat a benchmark index [chiefly the Powershares Dynamic funds, and the Zack's Micro cap and Small cap Indices (PZI), (PZJ)]. For those types of ETF's maybe star ratings could conceivably be useful, but probably won't be.

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