Some people say that exchange-traded funds (ETFs) have created an investing revolution. If that’s true, it should be noted, that I’ve observed the exact opposite at most major brokerages and fund researchers that produce and sell ETF research. It’s in these dark caverns we are witnessing a devolution of epic proportions.

Here’s an example of what I mean:

Recently, Morningstar assigned a five-star rating, its most coveted grade, to the iShares FTSE/Xinhua China 25 (Ticker: FXI). The fund consists of the Class H and Red Chip shares of the 25 largest and most liquid Chinese companies. Through 12/31/07, FXI has enjoyed startling annualized performance of 49.15 percent. Not bad.

Curiously, two ETFs that got featured in a January article published by Morningstar titled, “The Worst New ETFs of 2007” were funds investing in the same exact place as FXI; China. The funds that got dumped on were the First Trust ISE Chindia Index Fund (Ticker: FNI) and SPDRs S&P China ETF (Ticker: GXC). Question: Why does Morningstar give FNI and GXC the dubious title of “Worst New ETFs”, while giving FXI its highest rating of five-stars? Besides the fact that FXI has 3-years of performance history, what’s so different? Also, why didn’t Morningstar publish a list of worst new mutual funds? Couldn’t they find any candidates in the overpopulated field of 9,000 or so mutual funds? One would expect a more fair and balanced approach from such a diligent researcher.

Jeffrey Ptak, CFA, CPA at Morningstar explains, “too often investors pile into offerings like the following (FNI and GXC) just as performance--which had been white-hot only months before--is about to cool off, and they get burned in the process.”

Interestingly, neither Morningstar or Ptak warn anybody about FXI’s five-star rating, which was caused by the same sort of “white-hot performance” that eventually cools off and burns investors. This is a striking omission, don’t you think? Which ETF research from Morningstar should investors be listening to? Should it be the advice not to chase performance or the implied suggestion that five-star rated funds are the superior investment choice? Perhaps, the ultimate contradiction is that five-star rated funds are the epitome of hot performance!

The fact is Morningstar’s system for analyzing and rating ETFs, like that of its peers, is badly broken.

Particularly problematic, is that Morningstar attempts to evaluate ETFs through a mutual fund lens. Think of it as trying to officiate a basketball game with baseball rules. For example, Morningstar states, “We use total returns (of ETFs) based on net asset values (NAV), instead of market prices, for the ETF rating.” They explain, “These returns are most comparable to open-end fund returns and do not rely on market data that could potentially be stale.”

Even though many ETFs are closely hinged to their NAV, comparing ETF returns by their NAV price is erroneous because it’s not a true reflection of an investor’s experience. Unlike mutual funds, ETFs aren’t bought or sold at NAV, but rather at a fund’s market price on the exchange where they trade.  

For Morningstar to insinuate that the market price of ETFs is “stale”, resurrects bad memories of the delightful mutual fund scandals of yester-year. Wasn’t it mutual fund investors that lost $5 billion a year to arbitrageurs who were trading fund shares at outdated NAV or stale prices? (See research footnote below) By comparison, when have ETF investors ever suffered billion dollar losses because of stale prices?

If Morningstar and other fund analysts want to use a mutual fund standard for grading ETFs, they should start by comparing the expense ratios and tax-efficiency of ETFs versus corresponding mutual funds. These are the two places most fund investors are getting slammed the hardest. Maybe the reason they don’t do this is because it would alienate the mutual fund companies they pander to.

Here are other problems with Morningstar ETF ratings:

·     They cater to investor’s worst instincts and the propensity to performance chase by virtue of the fact that they’re backward looking and rely too heavily on past performance;

·     They use the total returns of funds based upon net asset value (NAV), instead of ETF market prices. The latter is a more accurate reflection of performance because it’s at market prices that investors are buying and selling their funds -  not at NAV;

·     They fail to give us insight about the tax-efficiency and expense ratio cost of ETFs relative to comparable mutual funds;

·     They fail to reveal meaningful information about how ETF indexes select and weight securities.

Regarding last point, a clear explanation of the underlying index strategy of ETFs is an essential element in correctly analyzing these funds. Because most fund analysts fail in this regard, it’s impossible for them to come to any meaningful or informed investment conclusions. (For help, visit ETFguide.com’s database by clicking here.)

Getting back to Chinese ETFs, let it be known that SPDRs S&P China ETF (Ticker: GXC) is one of the best funds to own if you want broad exposure to Chinese equities. Even though FXI is better known, GXC follows a more diversified index which includes stocks of all market sizes. As a result, GXC is a better representation of the total Chinese stock market versus FXI.

Beware of the ETF analysis being sold today. Antiquated methods and outdated techniques simply don’t work. After careful scrutiny, it’s likely you’ll come to the realization this sort of sub-standard investment research is far from just inadequate, but that it’s also contaminated with obvious biases and hidden agendas.

Put another way, the devolution in ETF research is unfortunately alive and well.

Ron DeLegge is the Editor of ETFguide.com, his opinions are his own and he doesn’t own any of the funds mentioned above.

ETFguide’s online database categorizes ETFs and other index based products according to a new financial tool called Index Strategy Boxes™. The tool is a graphic image arranged into 9 shapes that identifies how indexes select and weight securities.

Footnote: *”Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds,” (2003)

Eric Zitzewitz, Associate Professor of Economics - Dartmouth College