Advisers question usefulness of S&P's ETF ratings

The firm, a unit of The McGraw-Hill Cos. Inc. of New York, began making ETF reports available to advisers about two months ago, said Tom Graves, a director with the Equity Research Group at S&P.

The reports give an ETF a rating of overweight, market weight or underweight — essentially buy, hold or sell recommendations — based on a number of factors, including S&P's research into the fund's underlying holdings.

That approach separates S&P's ratings from those of such competitors as Morningstar Inc. of Chicago, Mr. Graves said.

“What we have done to differentiate ourselves is put a big focus on what the ETF holds and evaluating those holdings,” he said. “Our thinking is that the transparency of ETFs, the fact that people know what an ETF owns, offers an opportunity for analysis that didn't exist with actively managed mutual funds.”

Active fund managers generally don't like to disclose their holdings on a daily basis for fear of tipping their hand to arbitrageurs.

S&P, however, isn't the first to come to the conclusion that there may be some use to evaluating an ETFs underlying holdings.

In March 2006, Morningstar began rating ETFs with the same methodology it uses to rate traditional mutual funds, so investors could compare an ETF to traditional funds. That rating is a quantitative assessment of past performance —both return and risk — as measured from one to five stars.

But about a year ago, Morningstar also started to provide a separate valuation rating: a forward-looking, holdings-based assessment of a stock ETF's investment merit.

“This is analyst-driven research,” said Scott Burns, director of ETF analysis at Morningstar. “It tells investors, "Here's what's in the ETF, and here's what you should expect.'”

On the surface, it's not that much different than what S&P provides.

Some investors, however, may be more comfortable with equity analysis from S&P because it has been rating equities longer than Morningstar, said Jim Lowell, editor of the Forbes ETF Advisor, a monthly newsletter in Needham, Mass.

“If you are Morningstar, you have a lot of legwork to do,” he said.

That would appear to be true.

Morningstar analysts cover about 2,000 companies.

S&P, however, offers data and analysis on about 5,000 publicly held U.S. corporations.

Whether Morningstar rates fewer stocks than S&P doesn't matter, according to some financial advisers.

“I don't need to know the research on each individual stock,” said Richard Romey, president and founder of ETF Portfolio Solutions Inc. a Leawood, Kan., firm with $50 million under management. “I need to know the risk-reward characteristics of the ETF's underlying index over time.”

That's a different kind of analysis, he said.

Jeff Broadhurst, who was an analyst with Standard & Poor's before establishing Broadhurst Financial Advisors Inc. in Lansdale, Pa., four years ago, agreed.

“For me, I'm looking at how to provide asset class exposure in the most low-cost and tax-efficient way possible,” he said.

To say one ETF is better than another based on individual stocks “is somewhat irrelevant,” said Mr. Broadhurst, who has $20 million in assets under management.

Not all advisers are of the same opinion.

Ratings that look at the underlying stock holdings of equity ETFs — ratings that can be used as buy or sell recommendations — may be very useful to those advisers looking for guidance concerning allocation, said Tom Lydon, president of Global Trends Investments, a Newport Beach, Calif.-based firm that manages $75 million in assets.

“It all depends on how you're using the rating,” he said.

Mr. Lowell said he believed ratings based on an ETF's underlying holdings was the best way to evaluate the funds.

“We're always looking at ETFs not by name and index construction, but by their holdings and weightings,” said Mr. Lowell, who in addition to editing the ETF newsletter, is a partner and chief investment strategist at Adviser Investment Management Inc. of Newton, Mass., which manages more than $1 billion.

“I think it's a far more substantive and interesting approach,” than other ratings methods, he said.

E-mail David Hoffman at dhoffman@investmentnews.com.