The Morningstar Analyst Rating--which follows a Gold, Silver, Bronze, Neutral, and Negative scale--is forward looking. It expresses analysts’ conviction in a fund’s ability to beat its peers, after accounting for fees and risk, through a market cycle. We’ve been assigning Analyst Ratings to funds for a little more than six years, but with our 2016 launch we extended the ratings to ETFs for the first time.

Using the Analyst Rating, we believe investors can make sounder decisions about which ETFs to choose or avoid. Because the Analyst Rating we assign to ETFs follows the same methodology that we use to assign ratings to traditional mutual funds, it should also make it easier for investors to compare ETFs against relevant mutual funds.

That practice has grown more commonplace in recent years as ETFs have become more widely available and the popularity of low-cost, passive funds has taken hold.

A rating with purpose

The purpose of Morningstar’s qualitative, analyst driven research on funds is to identify those funds that we believe should be able to outperform a relevant peer group, within the context of the level of risk taken, over a market cycle. The pillars of our analysis are the same regardless of whether we are rating an index-tracking ETF or an actively managed fund: People, Process, Performance, Parent, and Price.

However, their relative impact on our overall assessment of a fund differs somewhat when it comes to analysing and rating ETFs. Obviously, keeping costs at a minimum is paramount in the context of running an index-tracking fund. As such, it should come as no surprise that our top-rated ETFs are not only among the lowest-cost options in their Morningstar Categories when compared with their actively managed peers, but also against other passive funds.

Although costs are critical, they are just one component of our holistic assessment of ETFs. We also closely scrutinise an ETF’s performance relative to peers in its category. And, as part of our Process Pillar assessment, we carefully analyse an ETF’s underlying benchmark to understand how the portfolio is built and maintained, as well as the techniques that the ETF’s managers employ to track the index with precision.

We tend to favour parent firms that put investors’ interests ahead of commercial goals and that align fund managers’ incentives accordingly. Of course, the skills and experience of the people managing the ETF are an important factor in our analysis.

In the management of ETFs, every 0.01% of performance counts, so it is vital to have a seasoned team in place. Thus, we evaluate these matters as part of the People Pillar assessment. In sum, we reserve our Morningstar Medalist ratings for those low-cost ETFs that we believe will tightly track a sensibly constructed index over a long-time frame.

We favour ETFs that are backed by experienced managers and sponsored by firms that are good stewards of investors’ capital. And we do so because we believe these attributes are likeliest to translate to outperformance when compared with a relevant peer group over a market cycle.

What people?

It’s a mistake to assume that management doesn’t matter when it comes to index funds and ETFs. Skilful managers and traders stand a better chance of tracking their benchmark over time, and they are better equipped to cope with challenging conditions. As is the case with active funds, we prefer teams with long track records. Teams that have run index funds and ETFs for several years--whether with their current firm or with a prior one--will generally earn higher marks than those who are relatively new to the job.

Similarly, we prefer teams that focus solely on running index funds and ETFs. We’d rather see indexing treated as a core competency than a sideline. Just as with active funds, we give teams that manage index funds and ETFs credit if they invest in their funds. It signals their commitment to the overall philosophy of indexing. That said, it is important to recognise that index fund and ETF managers are unique from their peers overseeing active funds.

The fact that members of teams managing index funds and/or ETFs are not as highly compensated as are managers of active funds, and that they tend to manage a relatively larger number of funds, somewhat diminishes the importance of co-investment.

As such, we tend to make a more holistic assessment of these managers’ compensation and how it aligns their interests with those of fund shareholders.

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Ben Johnson is director of passive funds research at Morningstar, based in Chicago.

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