New ETF analysis tools introduced last month from Morningstar and IndexUniverse may attract more assets to ETFs and expand the pool of ETFs that financial advisors use in client portfolios, said three ETF consultants interviewed by Registered Rep. In addition to the usual performance and holdings data, the tools allow investors to analyze ETF-specific factors, such as tracking error, liquidity, hidden costs, analysis of sector and capitalization allocation.

Today, advisors typically rely on a couple of providers for ETFs. The top three ETF providers—iShares, SSGA and Vanguard—account for 84.7 percent of U.S. ETF AUM, BlackRock reported at the end of January. Meanwhile, the ETF universe has already exploded in the last few years, with a proliferation of new products, many of them specialized, and a huge influx of assets. As of Jan. 31, there were 970 ETFs with assets of about $1 trillion, according to State Street Global Advisors’ January report.

Mentioned In This Article

“This is going to be the lighthouse that is needed for the sea of ETFs out there,” said Christian Magoon, CEO of Magoon Capital, an asset management consulting firm. Morningstar and Lipper, Magoon said, had a significant hand in growing the mutual fund industry by organizing it and making it more convenient to navigate, he added.

Richard Keary, principal and founder of Global ETF Advisors, a consultant, agreed. “The more information out there, the more opportunity [advisors] are going to have to make a decision.” Previously, people would buy ETFs that were associated with familiar brands, such as iShares or MSCI, he added. “Brand is no longer going to sell” ETFs; it’s going to be performance and cost, he said.

Tom Lydon, president of Global Trends Investments and editor of ETFtrends.com also believes such educational tools will help level the playing field among ETF providers and allow advisors to slice and dice the market. “It’s going to do nothing but help advisors be better equipped.”

After checking out the new tools, John Knowlton, an advisor with Portage, Mich.-based Oak Point Financial Group, said he’s going to use the Morningstar system to mine for funds and see if he should add to or change his repertoire of ETFs. At the moment, he mainly uses funds from BlackRock’s iShares, the market leader in the sphere with $448 billion in ETF assets, according to Morningstar. Knowlton is long-term bullish on commodities, so he’ll likely use one of the tools to screen for commodities ETFs, he said. He believes the new data could help smaller, newer ETFs make inroads.

“The more tools they can provide the better,” said Kevin Mahn, managing director and chief investment officer of wealth management firm Hennion & Walsh. There’s so much confusion out there as to what ETFs are, how they trade, and what indexes they track, he said. These new resources could open up a lot of doors by increasing investors’ comfort level with ETFs, Mahn said.

The New Toolkit

Last week, IndexUniverse rolled out its ETF Classification System, a free classification system available on its website. The system is “rules-based,” meaning IndexUniverse uses a lengthy rulebook that determines where each ETF fits in the system. The Classification System, which covers all ETFs and ETNs available on the market, drills down and sorts the products into different buckets and categories, depending on what the user’s looking for.

“In the past, if you wanted to answer a simple question, such as ‘how many India ETFs are there?’ there was no consistent way to do it,” said Matt Hougan, president of ETF analytics and
global head of editorial at IndexUniverse. “You’d have to go to four different websites and get four different answers.”

The company is also testing a prototype of its new ETF ratings and evaluation system, aptly named “ETF,” which stands for efficiency, tradability and fit. These are the three areas in which IndexUniverse will rate a fund. Advisors who sign up for the service can access two-page reports on each ETF, updated quarterly.

The efficiency measure provides classic index fund analysis, answering the question of whether the fund delivers on core promises to the investor. It looks at expense ratio, tracking error, tax exposure, ETN counterparty risk, securities lending activity and the likelihood a fund will be shut down. “We’re essentially calling out anything that might go wrong or surprise you in this fund,” Hougan said.

The tradability rating measures liquidity—in other words, how easy it is to trade a certain number of shares of an ETF and its underlying securities. Most people focus on spread and volume, and while those matter, it’s equally true that the underlying liquidity of the ETF securities also determines its overall liquidity, Hougan said.

Fit, the most important in Hougan’s view, analyzes how closely the ETF tracks its index. It breaks down the fund by holdings, market cap, and sector and measures how it differs from broad-based exposure, using the index as a measuring stick.

Meanwhile, on Feb. 7 Morningstar added four new data points for analyzing ETFs: tracking error, which measures a manager’s skill in tracking the index on a day-to-day basis; estimated holding cost, which analyzes direct and indirect costs, such as securities lending; market impact cost, a calculation of liquidity over the last six months; and portfolio concentration, which looks at how concentrated a fund is in certain countries and sectors.

According to Scott Burns, director of ETF, CEF, and alternative research, Morningstar has full coverage of all ETFs with the new data points, but not all of their underlying indexes. Eighty-five percent of the assets invested in ETFs are covered by the new system.

Beta Tools for Beta Vehicles

There are other ETF resources out there, as well. Marco Polo XTF offers a rules-based, quantitative ratings platform. ETF Trends provides over 20 model portfolios as well as basis analytics in researching ETFs, such as assets, volume, expenses, holdings/diversification and tracking error. ETF Database also offers ETF research and screeners. But none of these tools analyze ETF-specific factors like tracking error, underlying liquidity, and hidden costs. The new tools approach ETFs from a beta perspective, as opposed to an alpha perspective, said Hougan.

In the past, Morningstar and Lipper have taken their methodology for analyzing mutual funds and tried to fit ETFs into that same methodology, he added. Their legacy is toward the mutual fund audience and Morningstar’s Burns said the company has been fighting the image that they just do mutual funds. “Morningstar is funds, and the ‘F’ in ETF is ‘funds’ so that’s what we do,” he said.

IndexUniverse has been entrenched in the ETF space, as that is their core audience and expertise. Magoon believes IndexUniverse’s new third party assessment is on par with the mutual fund rating systems from Morningstar and Lipper.