ETF Ratings: Can You Boil It Down To One Letter?

Keeping on top of a burgeoning ETF universe can be difficult for independent financial advisers (IFAs). Given the lack of comprehensive information and a plethora of products, fund selection is no easy task.

This year so far has seen a number of research houses and consultancies look to address these problems via the launch of ETF rankings. TrackInsight and FE Trustnet are among the firms to have started rating passive funds within the last 12 months and consultancy shops FundCalibre, Square Mile and Rayner Spencer Mills Research look poised to follow suit.

The proliferation of such tools should prove a welcome boon for IFAs and investors – but some have their reservations. A straw poll of IFAs found that some are yet to warm up to the idea of using ratings to make their fund selection and due diligence process more efficient or well-informed.

“They are relatively new and I am always wary of new ‘rating systems’,” said Patrick Murphy, managing partner of advisory firm Zen Wealth, though he conceded he had no reasons yet to doubt their accuracy and would in theory welcome any resource which helped to inform investment decisions.

Meanwhile, some IFAs failed to see the value in ETF ratings altogether. Craig Burgess, managing director of EBI Portfolios, said he wouldn’t consider using any form of ratings.

“ETFs are even simpler vehicles than active managed funds,” he explained, “and it’s not difficult to identify the key metrics you need to ascertain especially if you are evidence based – buy and hold large well diversified indexes – and not a day trader.”

Understanding The Methodology

Understanding the differences in methodology between respective rating systems was a talking point – “does the criteria they use align with what we find important?” asked one IFA.

Koris International’s TrackInsight platform has a rating scheme which scores an ETF solely on its replication quality.

“We believe it is important to assess the very first promise of an ETF – to track its benchmark,” explained Jean-René Giraud, chief executive of the French investment advisory firm.

“We offer full transparency on our methodology so for those investors who share our views on the importance of tracking difference and tracking error and its robustness over time, our rating scheme allows them to very quickly scan a far-too-long list of investment vehicles,” he added.

Investors who prefer to analyse assets under management or average daily volume (ADV) of an ETF can find this information on TrackInsight, but these factors are not included in the fund rating, said Giraud. This is because the majority of ETF trading in Europe still takes place over the counter and is not transparent, therefore on-exchange liquidity could be misleading.

Looking Further Than Tracking

Consultancy and investment manager Twenty20 Investments launched a search tool of all London Stock Exchange-listed ETFs for its clients in May which uses ‘cluster analysis’ – meaning it ranks ETFs according to asset class.

“For most ETFs we do not see tracking error and tracking difference as much as a differentiator as many media commentators and rating proponents suggest,” said managing partner Allan Lane. “Of most interest is the capacity for loss, and to do that one has to get a handle on what the distribution of future returns might look like.”

Lane said he has met a lot of IFAs that have reservations about the limitations of the whole risk rating framework, and in many ways supports their view.

“The information we use ourselves and are offering to others aims to avoid those traps by going beyond a set of numbers from one to 10,” he explained.  “Let’s not forgot in the global financial crisis of 2008 the rating agencies made a terrible job of assessing the risk of sub-prime loans: that’s what we are trying to avoid and for nearly all ETFs that sounds like an achievable goal.”

How Accurate Are The Ratings?

Ultimately, it is important to know how the rating has been calculated and what the factors are being taken into account, according to Dominic Lobo, director of advisory firm Quadrant Group.

“If the nature of the rating is suitable this could potentially reduce a raft of providers to a more manageable population to select from,” he said.  It could also potentially save time and complement the firm’s own due diligence process, he added.

Now IFAs have the added burden of not only choosing an ETF, but also choosing a ratings or research shop as more and more come to market. How do you determine which are best to consider?

“I would probably test [the ETF] myself and rate them against my own appraisal initially,” said Lobo, “And if there was a similar outcome then I would hold such a rating in good regard.”

ETFs Versus Other Vehicles

Kristopher Heck, managing partner of Tanager Wealth Management said he didn’t see the merit in looking at ETF ratings in isolation, as opposed to comparing them with other instruments, and warned that some can be misleading because they are backward looking.

The current rating offerings in the UK marketplace are largely standalone ETF rankings – research house FE Trustnet became the first to offer ETF rankings alongside passive index funds in April this year.

“I would prefer to see ratings in the context of other mutual funds,” said Heck, “What other tools are at my disposal? It could be that for the particular exposure I am after, a unit trust might be more appropriate.”

Squaring Up Qualitative And Quantitative

Heck said it is insight into the “soft elements” of a fund that he finds most helpful.

“Qualitative information, like the experience of the management team, helps to give a level of comfort and inform the overall picture,” he said.

Indeed, most of the ratings tools on the market are firmly in the quantitative camp – with some firms arguing their use of unbiased ‘empirical science’ is a strong selling point.

“The fact that our ratings are completely quantitative mean that we are able to rate many more funds and are able to be completely impartial in doing so,” pointed out Craig Wilson, managing director at FE Trustnet.

However, Morningstar looks set to extend its forward-looking rating to include the ETF space, confirmed Ben Johnson, Morningstar’s director of passive fund research.

Morningstar Analyst has been rating passives in the UK market for just over two years but is yet to include ETFs. Five key qualitative ‘pillars’ are used (People, Parent, Process, Performance, and Price) and ‘medals’ ranging from ‘gold’ to ‘negative’  are assigned as a measure of conviction. 

“Investors are increasingly including ETFs as players on the pitch and adding them to our Morningstar Analyst ratings is in line with our overarching goal to create a level playing field across investment vehicles, be they active, passive - or in-between,” Johnson said.

Ratings Only One Step In Due Diligence

But the importance of independent due diligence, on top of using rankings, was stressed by all interviewees – across both the buy and the sell side.

“They should be used to narrow down a wide field of potential choices to a manageable short list, at which point qualitative and circumstantial factors should be taken into account,” said FE Trustnet’s Wilson, “It is in effect one additional tool in the adviser’s toolbox.”