Morningstar Advisor - Fall 2007 - (Page 21)

We also think that the depth and forwardlooking nature of our approach to ETF analysis sets it apart. Unlike other ETF research providers that use short-cut methods based on aggregate data, such as comparing composite fund valuation multiples, tallying historical earnings growth rates, or glomming onto technical indicators, our fair value estimates are based on the rigorous fundamental research of Morningstar’s stock analysts. Our analysts bore deeply into each firm’s financial filings, meet with company management, and attend industry conferences in an effort to gauge the intrinsic quality and risk of the business concerned. The new valuation ratings, which we’ll offer in tandem with the Morningstar Rating for ETFs, mark an advance from the price/fair value ratio in an important respect: They take the risk of the ETF’s underlying securities more fully into account while simultaneously considering an ETF portfolio’s diversification. To understand how the new ratings will better account for risk and diversification, consider a hypothetical example: Two ETFs, each trading at a 0.90 price/fair value ratio. At first blush, it appears that the two ETFs are equally compelling bargains—both are trading at a 10% discount to our analysts’ weightedaverage fair value estimates for the stocks in their portfolios. However, let’s suppose that the first ETF was a sector fund that devoted a big chunk of the portfolio to its top holding. In contrast, the second ETF tracked the broad U.S. stock market and spread its assets across hundreds of stocks. It stands to reason that the first ETF is the riskier of the two, as it’s less diversified across industries and securities. Yet, the price/ fair value ratio alone doesn’t convey the degree of risk associated with an ETF. Our new ratings address that shortcoming by considering an ETF’s level of portfolio diversification. Generally, the better diversified an ETF’s portfolio, the lower its risk, and vice versa. And the lower an ETF’s risk, the smaller the discount to fair value, or “margin of safety,” that we’d demand before recommending it. How does this principle express itself in our ratings? The threshold for recommending an ETF will vary depending on the risk it poses. For well-diversified ETFs, we’re likely to demand a relatively modest discount to fair value such as, say, 7% (which translates to a 0.93 price/fair value ratio). On the other hand, we might demand a 15% discount (0.85 price/ fair value) for a riskier ETF, such as a sector fund that’s levered to a common factor, such as our forecast of the price of crude oil. Taken together, this approach should ensure that our “recommended,” “neutral,” and “not recommended” ratings meaningfully reflect the risk and return trade-offs that ETFs offer. That said, we also recognize that, for all of its usefulness, a “recommended” or “not recommended” rating doesn’t necessarily answer a vital question: How much do I stand to gain from this investment? We’ve set out to answer that question as unambiguously as possible by providing an estimated expected return for each stock ETF that we cover. Importantly, the expected return figure that we derive is rooted in our fundamental research. Specifically, it’s tied to the relationship between a stock ETF’s market price, our fair value estimate for that ETF, and the weightedaverage cost of equity that our analysts use in modeling the stocks in the portfolio. The expected return is the rate of return that causes the ETF’s market price to converge to its fair value estimate over a specified time horizon, which we’re defining as three years. We can express a stock ETF’s expected return mathematically as follows: Expected Return 5 [ ETF Fair Value Estimate 3 (11 Cost of Equity) 3 / ETF Market Price ] (1/3) 2 1 As can be seen in the formula above, the higher a stock ETF’s fair value estimate in relation to its market price, the greater its expected return. Given the relationship between risk and return, it also stands to reason that the higher an ETF’s weighted-average cost of equity (that is, the intrinsic risk of its stock holdings), the higher its expected return, and so forth. Of course, an ETF’s expected return isn’t the end of the story. After all, a stock ETF that’s trading near fair value could offer a high expected return because its underlying portfolio holdings are riskier and, thus, carry higher costs of equity. In that case, while you’d stand to earn a higher return in absolute terms, that return would simply represent the minimal compensation that you’d require given the intrinsic risk of the ETF’s holdings. What we’re really after is excess return—that is, the difference between a stock ETF’s expected return and its “hurdle rate” (the sum of its weighted-average cost of equity and annual expense ratio). When an ETF’s expected return exceeds its hurdle rate, investors derive excess return. Not surprisingly, there’s a direct relationship between excess returns and our ratings: We’ll only recommend ETFs poised to deliver hefty excess returns. Not coincidentally, ETFs reach such a state when they trade at a reasonably steep discount to our fair value estimate—which is exactly the relationship that our rating system turns on. In the coming months, we will begin reporting a stock ETF’s expected return, hurdle rate, and expected excess return. Using that data, advisors should gain an even clearer picture of an ETF’s risk and return potential. Jeffrey Ptak, CPA, CFA, is Morningstar’s director of ETF analysis. MorningstarAdvisor.com 21 http://MorningstarAdvisor.com

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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