Morningstar to rate exchange traded funds (ETFs)

From the start of next year Morningstar will rate ETFs using the same scale it uses for active and index funds, which runs from gold, silver and bronze through to neutral and negative. The system will pit ETFs against actively managed funds within the same broad categories, and could mean ETFs are awarded neutral or negative ratings in areas in which active managers outperform.

ETFs are designed to replicate an index and the most common criteria used to assess ETFs are tracking difference and error. "We assign Gold, Silver, and Bronze for those funds that are best-suited to deliver precise tracking of sensibly constructed indexes at a low cost over a long period of time," explained Morningstar.

But Morningstar's ranking method means that ETFs are likely to receive negative ratings if they track narrow indices or are grouped in a category in which active managers are highly successful, such as UK Large Cap equities.

Hortense Bioy, director of passive fund research at Morningstar, said its fund ratings are vehicle-agnostic and designed to allow investors to choose the best-performing and most appropriate funds, whether passive or active, within broad categories.

"The rating is an expression of the ability of a fund to outperform its category peers," she said. "It is not a tracking ability rating. If a fund is rated as neutral that does not mean that it's a bad tracker, it just means that there are either better indices for that category or active managers who outperform the index."

But the new ranking could disappoint investors interested in comparing ETFs tracking certain indices with each other. The company uses five analysis criteria to evaluate funds: process, performance, people, parent and price. Ms Bioy said that, for ETFs, process and price were the metrics with the most impact on the overall rating. ETFs tracking indices favoured by the analysts will receive the highest ratings, along with those with the lowest ongoing charges.

"When we evaluate process we look at the construction of the index [tracked by the ETF] to ask whether it makes sense or not for investors," said Ms Bioy. "Is it representative of the market or too concentrated?" For example, with UK equities Morningstar favours the FTSE All-Share over the FTSE 100, which would affect the rating of ETFs tracking the latter.

Ms Bioy also said that focusing on low-cost ETFs would isolate those with the best tracking difference. ETFs will also be compared with each other and other passive funds within the performance analysis category.

Morningstar will also include in-depth reports on each ETF assessed, giving investors long-form analysis of their merits. "For example if we think an ETF tracks a bad index, but this ETF is the best product doing so, we will say that in the report," explained Ms Bioy.

The ETF ratings are an extension of the quantitative star-based ratings the company already uses for its funds, based on historic total returns. That ranking gives ETFs fewer stars if the index they track returns less than the best active manager. Around 300 ETFs will initially receive ratings and this will include 100 listed in Europe. Morningstar has selected the ETFs with the largest assets under management in the areas it thinks are most relevant to investors, and the list will include smart-beta and standard ETFs. The ratings are due to be published later this year.

Data company FE Trustnet launched a passive fund rating system last year. That rating system deliberately does not compare active and passive funds using the same metrics.

FE Trustnet said: "Unlike an active fund, which attempts to beat its designated benchmark, passive funds and ETFs attempt to track their index, with the aim of delivering a return as closely in line with it as possible. Comparing active and passive funds using the same rating methodology is therefore flawed."

FE Trustnet instead awards passive funds between one and five passive crowns based on their ability to track an index over a five-year period, and rates ETFs based on tracking difference, tracking error and fund size, which it uses as a proxy for liquidity. But, unlike Morningstar, it does not include a full report on each ETF it tracks.

EE Trustnet top-rated ETFs*

Source: Trustnet

*5-crown, physically replicating, LSE listed ETFs