Morningstar's Latest: Cheerleading ETF Performance
By Ron DeLegge, Editor
August 29, 2008

SAN DIEGO (ETFguide.com) – For decades, product manufactures have looked for ways to market their products to the public. Some of these strategies have included obtaining celebrity endorsements, getting favorable product reviews, or snagging other seals of approval.

Something similar is beginning to happen with exchange-traded funds (ETFs), a mutual fund cousin that trades like a stock.

Star Ratings
ETF families that manage alternative non-market index-based strategies have been looking for a way to tout their funds as “better mousetraps.” And now, their getting help.

The PowerShares Dynamic Large Cap Value Portfolio (Ticker: PWV) and the Dynamic Mid Cap Growth Portfolio (Ticker: PWJ) are the first ETFs of their kind to receive 5-star ratings by fund analyst Morningstar. The ratings coincide with the three-year anniversary of the funds.

Both ETFs follow Amex constructed indexes called “Intellidex.”

The indexes use an undisclosed quantitative selection criterion for picking stocks. After companies are chosen, they’re assigned a modified equal weighting.

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According to a Morningstar representative, “We think these ratings are going to go a long way toward reducing the general skepticism surrounding these new products and their relatively short track records.”

No they won’t. 

Instead, Morningstar’s ETF ratings will perpetrate the erroneous idea that quantitative constructed indexes are better than traditional indexes. And this is more easily accomplished with the helping hand of Morningstar’s backwards looking data that emphasizes hot past performance.

Encouraging Financial Puberty with Fund Ratings
Unable to successfully sell the hypothetical performance of experimental indexes, Morningstar ratings are just the panacea for ETF providers.

In fact, mutual fund ratings have become an important marketing tool for the fund industry. Highly rated funds (4 and 5-Star Funds) often experience the greatest amount of investor’s asset flows.

For that reason, many mutual fund companies make it a point to spend heavily on full page advertisements bragging about how many stars their funds have. Other fund companies are content with marketing their funds via faulty peer group comparisons. In either case, the goal is the same: To seduce people infected with financial puberty to invest money in hot performing funds.

Warning: As more ETFs attain three and five-year performance histories, fund ratings will become an important marketing tool.

Fund families that follow active and other experimental investment concepts are likely to use such ratings in a desperate attempt to justify their methodologies as superior or proven compared to traditional indexing strategies. Beware!

Numerous studies have shown that Morningstar ratings can’t be trusted in achieving future market outperformance.* As the asset base of hot performing funds increases, fund returns are negatively impacted. This frequently translates into market underperformance.

Even if ETFs using non-market strategies are able to achieve hot returns over a given time frame, second guessing the market has proven to be a losing strategy over long periods of time. On the other hand, using true market index funds as your portfolio’s foundation has proven to be a formula for long-term investment success.

It shouldn’t surprise anyone that ETFs following traditional indexes carry lower costs and still end up beating the vast majority of actively managed funds – even those selling themselves with hot performance via Morningstar ratings or Lipper Rankings.

Beating the market is easier said than done. And predicting the future winners with historical data or any other performance measures is perhaps, just as impossible. 

So be forewarned.

When advertisements selling hot ETF performance hit your newspaper, television, or favorite Websites – just remember where all of that performance chasing leads.

Inevitably, it takes your money down a long, ugly dead end road to absolutely no where.

*See: Mark Warshawsky, Mary DiCarlantonio and Lisa Mullan of TIAA-CREF Institute, “The Persistence of Morningstar Ratings” Financial Planning Association, Journal of Financial Planning September 2000 and Chiang, Kevin C.H., Kozhevnikov, Kirill and Wisen, Craig H., "The Ranking Properties of the Morningstar Risk-Adjusted Rating" March 2003