From the October 2007 issue of Wealth Manager Web • Subscribe!

The Wheat and the Chaff

Growth in the exchange traded fund market has been near exponential over the past two years, at least in the numbers of new ETFs hitting the market. There were 359 offerings at the end of last year; as of this writing, there are over 600. What's more, the rate of increase is unlikely to abate anytime soon, meaning ETFs could one day challenge the mutual fund industry's dominance. However, as the ETF universe expands, financial advisors are becoming increasingly addled by the tyranny of choice. Even today, many asset classes offer a wide swath of ETFs, making it increasingly complicated--not to mention time consuming--to construct efficient portfolios or execute tactical allocation strategies.

Some advisors attempt to distill the selection process by applying the same techniques they use for selecting any investment--namely, old-school fundamental analysis. Michael Krause, president of New York-based Alta Vista Independent Research, is a vocal proponent of the approach. "Fundamental analysis gives the clearest picture of investment merit," says Krause. "Since ETFs are transparent, you can analyze the underlying investments as easily as you can analyze any stock."

According to Krause, investment merit is determined by two factors: market conditions and stock fundamentals. "A company like General Electric is really a collection of businesses not entirely different from an ETF," he reasons. "Most analysts would compare GE's fundamentals to that of other industrial companies and to the market in general, and make an investment decision. The same approach can be applied to ETFs as well."

Krause's fundamental approach is conducive to evaluating cap-weighted, niche-oriented ETFs, where the top 10 holdings account for more than 50 percent of the weight. However, the approach grows unwieldy with equally-weighted ETFs that comprise 50 or 60 different holdings. In other instances, it's simply superfluous: The benefits of broad-based, cap-weighted ETFs such as the ubiquitous SPDR S&P 500 (SPY) and the iShares Russell 2000 (IWM) are readily apparent.

Krause's AltaVista claims to be the only firm that provides ratings based on fundamentals analysis. According to Krause, the AltaVista Long Term Annual Return (ALTAR) forecast is a proprietary measure of an ETF's likely return in the coming years and is based on the following equation:

(average return on equity)/

(price/book value) - expenses

Similarly, Morningstar uses a bottom-up analytical approach to produce a number that indicates whether the ETF is overvalued or undervalued and by how much. "If the number is above one, then the ETF is overvalued," explains Sonya Morris, fund analyst at Morningstar. "If it's below one, then the ETF is undervalued."

Morningstar's ubiquitous Star Rating system is another popular distilling option. The system calculates risk-adjusted returns by adjusting total return with sales charges, the risk-free rate and risk. The system quantitatively assesses risk-adjusted performance and rates funds from one to five stars.

But there's a rub with both the AltaVista and Morningstar services: lack of comprehensive coverage. AltaVista covers only 45 ETFs (though it claims those ETFs account for 70 percent of U.S. assets), while Morningstar generally doesn't rate ETFs with less than a year's trading history.

The XTF Way

Enter XTF Advisors LLC and its free ETF rating system (at XTF.com), which evaluates every ETF with at least a six-month trading history. XTF employs a proprietary database to construct a framework for evaluating ETFs individually and relative to other ETFs on common portfolio-construction metrics.

"The idea is to examine asset class for risk and return, which our rating system does by examining several factors from a top-down perspective," says Susan Hunt, director of marketing and product development at XTF. "The rating system equally weights specific metrics and provides ready numbers on these metrics that advisors can compare with other ETFs."

The XTF rating service is bifurcated into two broad categories: structural integrity and investment integrity. The structural-integrity component rates tracking error; market impact (defined as the price impact of executing a hypothetical trade of 50,000 ETF shares); daily alpha; capital gains; tax efficiency; concentration risk; management expenses; and the bid-ask ratio. Each measure for an ETF is compared with other ETFs in its asset class, with the highest ranked ETF receiving a rating of 100 and the lowest ranked, a zero.

Here's a real-world ranking: The expense ratio for the Rydex S&P 500 Pure Value ETF (RPV) is 0.3 percent and produces an XTF expense ranking of 69.70. In other words, RPV is in the top third of all equity ETFs thanks to its paucity of fees, according to XTF.

The structural-integrity component concentrates on the operational capabilities of each ETF and, therefore, uses the same metrics for all ETF's. The investment metrics, in contrast, focus on performance and investment fundamentals of each ETF and will differ depending on asset class.

Investment metrics include risk-adjusted historical performance (six-month, one-, three- and five-year); yield measures, including earnings and dividend yields and yield-to-maturity figures (bonds only); short-term versus long-term price movement; and diversification score, which applies to commodities and currencies to measure the overall diversification ( for example, across asset classes, industries, geography) within an ETF.

Looking at dividend yield, RPV's 2.64 percent yield garners an XTF rating of 80.80, putting it in the top 20 percent of equity ETFs. In other areas, though--earnings yield and momentum, for example--RPV falls short, ranking in the lower half of equity ETFs.

XTF's final evaluation combines the structural and investment ratings with a proprietary weighting scheme to produce an overall rating, with 10 being the highest and 1 the lowest. On this front, RPV earns an overall rating of 6.9, which is actually below average, because its peer group of eight other ETFs with a similar investment style earns a collective score of 7.1

Special Attention

XTF and its competitors provide an efficient, cost-effective tool for evaluating ETFs. Still, many advisors want to vet the evaluation process more closely. Hunt admits that XTF adjusts the weights of its metrics when constructing its own portfolios. "We look at the overall picture," she says. "But we don't necessarily equally weigh each metric when we are constructing portfolios for our separately managed accounts."

So which metrics should receive additional emphasis? Expenses, trading efficiency, tracking error, concentration risk, tax efficiency, and performance tend to rank high on the vetting totem.

But arguably, no metric ranks higher than expenses, especially for broad-based ETFs used in strategic portfolios, for the more expensive the ETF, the more it will lag its benchmark index.

Expenses can also readily reveal indexing strategy, because they correlate positively with activity and allocation sophistication, according to Rick Ferri, CEO of Troy, Mich.-based Portfolio Solutions. "If you see 10 or 15 basis points, you have a passive, cap-weighted ETF that's easily replicable," he says. "If you have 50 or 60 basis points, you have a customized strategy."

Trading efficiency impacts expenses as well. Fortunately, most ETFs trade efficiently, regardless of size. The S&P Deposit Receipts (SPY) ETF, which trades 130 million shares daily, rarely has a bid-ask spread greater than a penny. Meanwhile, the much smaller Powershares Dynamic Utilities Portfolio (PUI) ETF, which averages less than 27,000 shares traded daily, rarely exceeds three cents in its bid-ask spread.

Theoretically, ETFs should closely track their underlying index before fees (ETF investing is putatively a passive strategy). Any difference produces a tracking error. The lower the tracking error, the better the ETF manager is replicating the stated benchmark. But many ETFs don't perfectly match every security in their benchmark, so a security selection process is used, subject to management discretion, which can add or subtract value.

Many times the selection process is a product of necessity. "You run into problems with narrowly focused ETFs where the percentage of stock in the index is greater than regulators allow," says Morningstar's Sonya Morris.. "For example, one company might be 40 percent of the index, but regulatory requirements might preclude that much concentration in the ETF."

Concentrated portfolios, in turn, impact unsystematic risk: In fact, the fewer the securities, the higher the unsystematic risk. But unsystematic risk isn't limited to security-concentrated. When an ETF sponsor employs a single-metric strategy, such as certain fundamentally weighted allocation strategies, certain sectors tend to be more heavily weighted, so the ETF could have many issues that are concentrated in a few sectors.

"The problem when you focus on one allocation metric is that you get pretty intense sector biases," says Robert Arnott, president of Research Affililiates in Pasadena, Calif. "Just look at some of the dividend-weighted strategies where over half the dividends are paid by consumer durables and financial service companies."

Additional risk from portfolio concentration is sometimes sought, particularly for certain tactical-allocation strategies. For example, an advisor bullish on specific sectors in China might want to use an ETF like iShares FTSE/Xinhua China 25 (FXI), which holds 25 stocks, instead of a more diversified ETF like the SPDR S&P China (GXC), which holds 126 stocks.

Tax efficiency, especially for investments held outside tax-deferred accounts, is another area of perpetual interest. On the capital-gains front, ETFs generally excel; they don't need to cover redemptions by selling securities, and because they track an index that is passively managed, turnover occurs less frequently than in most actively managed mutual funds.

Dividends are another matter. To qualify at the lower 15 percent rate, a dividend-paying stock has to be owned by both the investor and the ETF for at least 61 of the 121 days surrounding the ex-dividend date. Lower levels of qualified dividend income can produce a higher tax bill. And some dividends such as real estate investment trusts and certain foreign-company ETFs are simply ineligible for the lower rate.

Finally, everyone measures performance. The most obvious measure is an ETF versus a comparable benchmark. An easy example would be the Vanguard Large-Cap versus the S&P 500.

Of course, identifying the proper benchmark can be tricky. Niche ETFs, like HealthShares Dermatology and Wound Care (HRW), don't readily lend themselves to broad-based benchmark comparisons, and possibly not to sector or industry benchmarks either. In these and other cases, Sharpe ratios--calculated by subtracting the risk-free rate from return and dividing the result by the standard deviation to capture risk-adjusted performance--are handy yardsticks. In short, the Sharpe ratio measures return per unit of risk, putting all ETFs on an equal footing.

Unfortunately, statistical measures can deceive, especially on investments with short trading histories. "Basically, you can end up with a huge error on the mean return that will produce a standard deviation and, therefore, a Sharpe ratio that is essentially worthless," says Steven Evanson, founder of Carmel, Calif.-based Evanson Asset Management.

Evanson's admonition can be extended to measuring newbie ETFs, even those based on broader indices. A short trading history begs scouring the financial pages for a closely related mutual fund to serve as a proxy in order to better understand how the ETF reacts in various economic environments.

ETFs are growing up. The tools to analyze them are growing up as well.

Stephen Phillip Brown, CFA, a freelance financial writer based in Brighton, Colo., has written for Barron's, CFA Magazine, The Financial Journalist, the Denver Post and Rocky Mountain News. He can be reached at sphillipbrown@consultant.com.

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