star gazing

Content provided by Case Eichenberger, CLS Client Portfolio Manager

CLS portfolio managers often get questions from clients about Morningstar’s renowned star rating system. But these days, the questions are more commonly about exchange-traded funds (ETFs) than mutual funds. Some of the most common ones are: Why do some ETFs that CLS uses have low Morningstar Rating™? And, why don’t we just use the highest-rated Morningstar ETFs to build portfolios?

As one of the largest active money managers of ETFs*, we pride ourselves on our ETF knowledge. So, here’s our answer, (but first, remember that an overwhelming majority of ETFs are passive and exist simply to track an index). The ETFs aren’t actively managed, which means it is up to the manager (CLS) to add value by combining ETFs to suit the investor’s risk tolerance (aggressive, conservative, etc.), objective (accumulation, income, etc.), or a combination of other factors.

Currently, Morningstar’s rating methodology  for ETFs is very similar to that used for mutual funds. The ratings are based on risk-adjusted performance, and ETFs are measured against others in their respective category. For example, the iShares Core High Dividend ETF (HDV) is a two-star fund in the Large (Cap) Value category. This rating is below average for the category, so why use this ETF? Well, that brings us to our first point: the objective, or fit, of the fund in a portfolio.

Let’s say an investor expresses the need for immediate income generation from his/her assets to live on. How would you gain access to large value equity space in the U.S.? Would you buy the highest Morningstar-rated fund with the largest assets in the category? If so, you could buy the Vanguard Value ETF (VTV), which has a four-star rating. But remember, the investor needs to tilt towards dividend yield for income. This is where HDV may better satisfy the investor’s objectives. HDV has a 12-month yield of approximately 4% while VTV is just approximately 2%. How the fund fits the objective is important.

Let’s look at it another way. Let’s say an investor is heavily invested in U.S. stocks, and would like to diversify further with international equities, specifically in Japan. A quick survey of Morningstar’s ratings could lead you to Deutsche X-trackers MSCI Japan Hedged ETF (DBJP). This ETF has a five-star rating. Compare this to the iShares MSCI Japan ETF (EWJ), which has three stars. The choice seems obvious, doesn’t it? Not so fast. You have to first deconstruct the difference. In this case it is due to the Japanese currency (yen) being devalued against the American dollar. DBJP takes out the yen exposure, while EWJ has currency exposure. Would you rather own a currency-hedged ETF (DBJP) or let the currency diversification help in the long run (EWJ)? The choice isn’t so clear anymore. Again, it comes down to the manager to add value here.

So how does Morningstar calculate ratings? High returns are rewarded; that makes sense. But what if an ETF has much higher returns than its benchmark, and another ETF has lower returns but is more in line with its benchmark? Which would you choose? If you choose the one with the lowest tracking error, it may have lower returns, but you may be more comfortable with what you’re getting. And, again, it is the manager’s job to add value in such choices.

OK, we’ve pointed out why Morningstar’s ETF ratings may not be the best basis for investing decisions. What else should be looked at? With experience in the ETF space for well over 10 years, CLS tracks all the ETFs (over 1700) and has variable measures on each. We look at the expense ratio, the cost of holding, and the market impact cost of trading the ETF. We also look at the structures of the ETF for possible tax considerations, such as whether it distributes a K-1. We host ETF providers at our Omaha, Neb. headquarters to conduct due diligence, and we send out due diligence surveys to providers and visit their headquarters.

We do all this to become even better at determining which ETF is best for the investor, without bias and within a high fiduciary standard. So what’s a better basis for investing decisions? There’s your answer.

*Morningstar, April 2015
This material does not constitute any representation as to the suitability or appropriateness of any security, financial product or instrument.  There is no guarantee that investment in any program or strategy discussed herein will be profitable or will not incur loss.  This information is prepared for general information only.  It does not have regard to the specific investment objectives, financial situation, and the particular needs of any specific person who may receive this report.  Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this report and should understand that statements regarding future prospects may not be realized.  Investors should note that security values may fluctuate and that each security’s price or value may rise or fall.  Accordingly, investors may receive back less than originally invested.  Past performance is not a guide to future performance.  Individual client accounts may vary.  Investing in any security involves certain non-diversifiable risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk.  These risks are in addition to any specific, or diversifiable, risks associated with particular investment styles or strategies.
An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket.  ETFs are subject to the same risks as an individual stock, as well as additional risks based on the sector the ETF invests in.
The Morningstar Rating™ rates funds on a risk-adjusted measure, and stars are assigned using a scale further described in Morningstar’s methodology. CLS is not affiliated with Morningstar or any of the companies listed above. While some CLS portfolios may contain one or more of the specific funds mentioned, CLS is not making any comment as to the suitability of these, or any investment product for use in any portfolio.