Morningstar Advisor - August/September 2011 - (Page 58)

Gray Matters Better Ways to Look at ETFs By Michael Rawson Improved measures give investors a clearer view of ETF performance. Passive funds offer investors a tempting trade-off: no risk of substantial underperformance but nearly zero chance of exceeding the benchmark. In the other words, passive investors should expect near-zero alpha; returns should trail the index only by the disclosed expenses of the fund. In practice, things are not so clear. Passive funds certainly track their indexes much more closely than even the most diversified of active managers, but performance rarely matches that clean equation of index return minus disclosed expenses (Exhibit 1). Investors still need to be careful about choosing the right passive fund, and there are unique issues in measuring passive fund performance. Morningstar is introducing new data points— called Estimated Holding Cost, Tracking Volatility, and Market Impact—to help investors select the right ETF for their needs. But before we dive into these new measures, we first must explore how passive management should be assessed in theory. Long-Term Tracking Differences Investors who hold funds for many years may not care much about random short-term deviations, but any predictable long-term drag against the index should be minimized. These drags can occur for a variety of reasons, but most come from trading costs that aren’t included in disclosed management or administrative fees. These trading costs are a function of the turnover inherent in the tracked index (small-cap and non-market-weighted indexes require far more trading each year), the liquidity 58 Morningstar Advisor August/September 2011

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011