Ratings may lead to more ETF acceptance

Nov 13, 2006 @ 12:01 am

By David Hoffman

PHILADELPHIA - The push by some research firms to rate exchange traded funds may lead to even wider acceptance of ETFs among investors, according to industry observers.

"People would use ETFs more if they understood them better," said James Kibler, president of Eldridge Financial Planning LLC in New York. "They have an aversion to investing in things they don't understand."

AltaVista Independent Research Inc. of New York last month began offering fundamentally driven research on ETFs online. Using its website, investors can examine the aggregate earnings growth, price-earnings ratio or dividend yield of an ETF.

They can then use the site's valuation tools to compare those figures with those for other ETFs.

"In a nutshell, my approach to ETFs is to be forward-looking by evaluating them based on fundamentals such as earnings growth … much like stocks," Michael Krause, president and founder of AltaVista, said via e-mail.

AltaVista isn't the only firm trying to help investors compare ETFs.

In March, Morningstar Inc. of Chicago raised eyebrows when it began rating ETFs the same way it rates mutual funds.

Because ETFs typically track stock market indexes, critics doubts whether Morningstar's rating offers anything of value to investors.

"To the extent that you know what the index [an ETF is based on] will do, further analysis is not really necessary," Mr. Kibler said.

Of course, some disagree.

"Most of what I'm concerned about is how closely [ETFs] track the index, and the analysis [Morningstar] gives us is pretty good for that," said Benjamin Tobias, president of Tobias Financial Advisors Inc. of Plantation, Fla.

While advisers are divided over whether Morningstar's ratings are useful, many think that the ratings will make ETFs even more popular than they already are.

"People rely on Morningstar pretty heavily," said Thomas F. "Tif" Joyce, president of Joyce Financial Management in Sebastopol, Calif. "I think it will make a difference."

Jim King, a wealth manager with Balasa Dinverno & Foltz LLC in Itasca, Ill., said of the new ETF ratings, "I think it adds credibility. It should lead to more acceptance."

ETFs are already popular among investors.

At the end of October, ETFs held $388 billion in assets, up 28% from the amount at the start of the year, according to State Street Global Advisors in Boston. The number of ETFs now totals 329, up from 204 at the start of the year, SSgA said.

As a result of that popularity, companies have begun launching ETFs that track obscure indexes.

Last month, for example, such companies as WisdomTree Investments Inc. of New York, PowerShares Capital Management LLC of Wheaton, Ill., and Van Eck Associates Corp. of New York launched ETFs that track relatively unknown indexes.

Making matters even more confusing for investors, many ETFs have obtained exemptive relief from the Securities and Exchange Commission, so dealers may effect secondary-market transactions in ETF shares without providing a prospectus.

As a condition to this relief, each listing exchange has adopted rules requiring the delivery of a "product description" instead of a prospectus.

The SEC has suggested that that may not be enough. It is looking into requiring additional ETF disclosure.

Ratings usefulness debated

In recent months, the benefits of ETF ratings have been widely debated.

Morningstar's ETF ratings may be misleading, said Jim Wiandt, president of Index Publications LLC in New York.

For example, investors may be tempted to invest in the $1.7 billion Rydex S&P Equal Weight ETF from Rydex Investments of Rockville, Md., because of its five-star rating from Morningstar, he said.

What they may not know, however, is that unlike capitalization-weighted funds, which give more weight to the largest stocks within an index, the Rydex ETF weights all stocks equally regardless of market capitalization.

As a result, it has a much more pronounced small- and mid-cap tilt, said Mr. Wiandt, publisher of the Journal of Indexes and the Exchange-Traded Funds Report.

That tilt is what has allowed it to outperform the Standard & Poor's 500 stock index, and that outperformance is the reason why it received five stars, he said.

"It's all about what happens to be hot," Mr. Wiandt said.

Morningstar, for its part, said its ETF rating system was never intended to be the final word on whether a particular ETF is suitable.

"I think that the star ratings can be useful screens, but they're not the be-all, end-all," said Sonya Morris, editor of Morningstar ETFInvestor.

A better way to analyze ETFs is to compare them based on the fundamentals of the underlying stocks, industry experts said.

Morningstar does provide some of that analysis, as do some of the brokerage firms, such as Morgan Stanley of New York.

But it's still difficult to compare ETFs based on fundamentals, said Marin Appel, chief executive of Appel Asset Management Corp. in Great Neck, N.Y.

Although AltaVista's approach does compare ETFs based on fundamentals, that approach may be out of reach for most investors. That's because a basic subscription to AltaVista's service costs $29 a month or $299 a year.

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