Morningstar Advisor - Fall 2007 - (Page 20)

Gray Matters In general, the monthly total return on a security is the sum of its income return (the ratio of the income it generates for the month to its price at the beginning of the month, expressed as a percent) and its percentage price change for the month. For long-term securities, such as stocks and long-term bonds, the percentage price change is the dominant portion of its monthly total return. Hence, the lack of serial correlation in percentage price changes translates directly into a lack of serial correlation in monthly total returns, even if the income return is highly serially correlated (as it usually is). For short-term securities, such as ultrashort bonds, most of the monthly total return is income return. Therefore, monthly returns on portfolios of short-term securities, such as ultrashort bond funds, tend to exhibit serial correlation, as our analysis suggests. That observation allows us to answer our reader’s second question: Could a relatively high serial correlation imply that a mutual fund has a higher consistency of returns, which many would regard as a desirable feature? The answer is yes for funds that focus on short-term securities, as such funds consistently provide returns for their investors in the form of income. However, this is only a desirable feature for investors who are willing to accept the relatively low level of longterm returns that comes with low-risk investments. Paul D. Kaplan, Ph.D., CFA, is vice president of quantitative research at Morningstar. Valuating ETFs, the Equity Analyst’s Way Morningstar is retooling its ETF analysis. The centerpiece of this effort is a new measure called valuation-based ETF ratings. The new ratings, which will be rolled out early next year, will help advisors and investors more precisely gauge whether an ETF is cheap, dear, or reasonably priced. The ratings build upon the Morningstar price/ fair value ratio. That measure compares an equity ETF’s market price with the weightedaverage fair value—as determined by Morningstar analysts—of the stocks in its portfolio. The lower an ETF’s price/fair value ratio, the more reasonably priced we consider it, and vice versa. Using the price/fair value ratio, investors can better discern an ETF’s fundamental attractiveness, thereby making it easier to exploit opportunities as they arise in particular market segments. The new valuation-based ETF ratings take things a step further. Provided that we have adequate coverage of an equity ETF’s underlying stocks, we’ll publish a “recommended,” “neutral,” or “not recommended” rating for the ETF to indicate its attractiveness. (We’ll also accompany each rating with a fair value estimate for the ETF as well as Consider Buying and Consider Selling prices, just as we do on our stock analyst reports.) The foundation of the new measure is Morningstar’s 100-plus equity analysts, who follow more than 2,000 stocks spanning virtually every industry and six continents. In addition to valuable perspective, this coverage breadth affords us the unique ability to evaluate even the most sprawling ETF portfolios from the bottom up. Take SPDRs SPY, which tracks the S&P 500 Index and is the world’s largest ETF. Because we cover all but a handful of that benchmark’s 500 stocks, we can assess the SPDRs’ valuation far more accurately than is possible using error-prone methods like macroeconomic analysis. That same story holds for other popular ETFs and the prominent indexes they track, including PowerShares QQQ, iShares Russell 1000 IWB, and Diamonds Trust DIA. All told, we cover more than 70% of the stocks in nearly 300 U.S.-listed stock ETFs, representing a big swath of the universe when measured by assets or trading volume. 20 Morningstar Advisor Fall 2007

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Fall 2007

Morningstar Advisor Fall 2007 Features Departments Letter from the Editor Inbox 10 Years After: Developing Markets Make Progress Research Briefs Investors Should Adjust Their Home Bias Few Mutual Funds Exhibit Serial Correlation Valuating ETFs, the Equity Analyst's Way It’s All About Location See the World (Differently) The Return of the Global Flexible Investor Map of International Value Sound as a Loonie? Fair Exchange In Their Own Worlds A Good Read Putting Their Heads Together Buying Protection Scoping Out Easy-to-Use Funds Finding Good Stewards Consumer Firms Go Global Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities New at Morningstar The Whole Wide World

Morningstar Advisor - Fall 2007

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