ETF model portfolios to be ranked by Morningstar – stars next?

Morningstar Inc. soon will begin ranking — and possibly even applying its popular star rating to — exchange-traded-fund model portfolios used by financial advisers, a first for the burgeoning industry.

The firm’s initiative, which it hopes to complete this year, comes just as IndexUniverse.com, a provider of ETF research, is launching its own ETF ratings — putting it in head-to-head competition with Morningstar.

The arms race between Morningstar and IndexUniverse.com to provide more research on ETFs is welcome news for advisers, who increasingly are using these products.

Last year, ETF assets surpassed $1 trillion.

But some experts wonder if Morningstar can spread its wings beyond its traditional fund star model when rating model portfolios that include ETFs.

“The problem is that there are a lot of legacy issues with the Morningstar star system,” said Christian Magoon, an ETF consultant and chief executive of Magoon Capital LLC.

The firm just can’t apply its old fund star methodology to ETFs and model portfolios, he said.

Morningstar recognizes that rating ETF model portfolios is a different game, said Scott Burns, an ETF analyst at Morningstar, who is spearheading the initiative.

The firm wants to rank model portfolios of ETFs because as more advisers move from commission-based to fee-based businesses, they are using model portfolios containing ETFs. In some instances, they develop their own model portfolios, but many are paying money to use other money managers’ models.

Regulators and others are worried that some of these model portfolios are making performance claims that can’t be verified. In September, the Securities and Exchange Commission said that it was examining the use of ETF model portfolios.

“We want to bring some order to chaos and try to weed out some of the bad apples,” Mr. Burns said.

Morningstar is working with ETF sponsors to aggregate model portfolio information, and so far has data on 312 models. The firm is still in the process of figuring out how it will classify the model portfolios, but it has established that to be eligible for a ranking, the model portfolio has to have 50% in ETF assets and a three-year track record.

Getting the data on the model portfolios will be a key challenge, Mr. Burns said, noting that while this project is his 2011 initiative, he can’t provide a date by which the ratings will launch.

“It’s not as simple as going in and scraping prospectuses,” he said.

If Morningstar can get sizable data for each category, it will then decide whether it will take the rankings a step further with star ratings, Mr. Burns said.

Morningstar’s efforts in the ETF industry come as it faces increased competition from IndexUniverse.com, which last week said at its Inside ETFs Conference that it will begin rating ETFs.

IndexUniverse.com’s ratings will grade each ETF based on three categories: efficiency, tradability and its so-called “fit” score.

In terms of efficiency, the firm will consider whether ETFs track their respective indexes. It will also consider how taxes affect a portfolio and whether the fund engages in potentially risky activities, such as securities lending, which could lower the fund’s score.

For tradability, IndexUniverse.com has teamed up with Knight Capital Group Inc. to gauge the median premium or discount at which the ETF has traded for the past 12 months, as well as the maximum and minimum premium or discounts.

The fit score is designed to measure how well a fund represents the particular sector it follows. The way it works is this: IndexUniverse.com picks a broad-based, market-cap-weighted benchmark for each investment category and uses that benchmark as a yardstick to measure how closely the fund follows that category.

“Fit would be hurt for an ETF that was making different allocations than the market,” said Dave Nadig, IndexUniverse.com’s director of research.

IndexUniverse.com hasn’t decided how it will charge for its ratings but thinks that it will be able to compete with Morningstar, the proverbial 800-pound gorilla in the ratings game.

“Their fundamental rankings look at the persistence of performance, and we think that’s a flawed way of approaching ETFs,” Mr. Nadig said. “An ETF based on the S&P [500] can lose a star because the market went down, and we think that doesn’t make sense.”

Morningstar acknowledged that its ratings need improvement and last week also announced the addition of new data points to its ETF analytics that will allow investors to see the total cost in dollars of each fund.

“Our new data points address how ETFs are different than mutual funds,” Mr. Burns said.

The points will, among other things, examine tracking errors of ETFs on a day-to-day basis, as well as an estimated holding cost of a fund. That metric goes beyond expense ratios by also measuring the indirect expenses and payments of an ETF.

Morningstar plans to make its rankings even more interactive so that advisers can plug in their ETF holdings and see how they rank for a specific period of time.

“We are moving away from a static model to an interactive one,” Mr. Burns said.

Advisers and ETF providers welcome the competition in the ETF research industry and think that the fact that Morningstar is taking the race one step ahead by rating model portfolios is significant.

“This could be an independent verification of our performance,” said William E. Koehler, chief investment officer of ETF Portfolio Partners Inc., an RIA that offers model portfolios with ETFs.

With the Morningstar ratings, investors and advisers can see what they are investing in, he said. However, Mr. Koehler and other industry observers did share concerns about how the firm will categorize model portfolios.

Specifically, he said that it will be interesting to see if Morningstar takes into consideration the certifications that the adviser has and the fees of the portfolios.

Another question that some advisers may ask is if Morning-star’s ranking model portfolios is a conflict of interest because it offers its own wrap programs, Mr. Koeher said.

“Some may ask if they will just do ratings that make their own programs look good,” he said.

But Mr. Burns said that the rankings will be purely quantitative, with no room for qualitative analysis.

“These will not be subjective in any way,” he said.

For its part, IndexUniverse.com has no plans to get into the model portfolio ratings game.

“It’s a great business opportunity for someone else,” said Matt Hougan, president of ETF analytics at IndexUniverse.com.

E-mail Jessica Toonkel at [email protected].

Related Topics: Morningstar Inc.