You’ve decided to buy an ETF. Now comes the hard part – narrowing the list down to one.

The first step is understanding the role this ETF will play in your portfolio. Having goals and an investment strategy in place will help, as Morningstar’s Mark LaMonica explores in his step-by-step process for choosing an ETF.

Once you know what you’re looking for, there are a few things that can help you narrow the field, as Morningstar associate director of manager research, Justin Walsh outlines below.

Tip 1: Look for a Morningstar ‘medalist’ rating


This is Morningstar’s analysis of whether a fund will be able to produce excess returns after fees, in the future.

We assign the ratings on a five-tier scale with three positive ratings of Gold, Silver, and Bronze; a Neutral rating; and a Negative rating.

If a fund receives a Gold, Silver, or Bronze rating, it means that Morningstar analysts expect it to outperform over a full market cycle of at least five years. 

And history shows that medalist-rated funds have outperformed funds rated neutral or negative, Walsh says.

“Short term it's been mostly positive and longer term, as in 5- and 10-years’ timeframes this approach has been successful in terms of those that we ranked gold coming out with a strongest relative performance against their category peer group and those that we rate negatively having negative outcomes overall – on balance overall which is what you would want to see,” he says.

“Ultimately what we’re trying to do is we’re trying to pick those funds that, after fees, will outperform the category peer. So, when we look at it in that way and look at results of that, we’ve found that over 5- and 10-year periods so far to date, that our approach has been successful.”

Investor subscribers can use Morningstar’s investment screener tool to filter for medalist rated funds, as shown in the example below.

Morningstar screener

Tip 2: Use caution when chasing yield


If you’re looking for an income-producing ETF, Walsh says investors should avoid falling into what’s called a dividend trap.

“A dividend trap is that a stock tends to pay high dividend but falls in value,” he says.

“So, on your analysis yes, the distribution stays consistently high, but the value of that capital that you’ve invested falls, and that’s something you would like to avoid because at the end of the day when you’re investing in the stock market and in shares, you would like your capital to go up and you would also like your dividends to go up," he says.

“If your capital keeps on falling, over time your dividend will fall.”

As explored in this recent podcast episode, Morningstar analysts cover four Australian dividend ETFs:

  • iShares S&P/ASX Dividend Opportunities ETF (IHD)
  • Vanguard Australian Shares High Yield ETF (VHY)
  • Russel High Dividend Australia Shares ETF (RDV)
  • SPDR MSCI Australia Select High Dividend Yield ETF (SYI)

Listen to the full interview.

The investment screener shows two of the four Australian dividend ETFs under Morningstar coverage hold a Bronze rating.

Morningstar investment screener: Dividend ETFs

Tip 3: Be cautious of the ‘next big thing’


Thematic investing involves betting on a predicted or long-term trend or theme—such as the transition to green energy or artificial intelligence—by choosing investments that are likely to benefit from that trend.

By purchasing ‘thematic’ ETFs, investors can get exposure to everything from video games to cloud computing and even food security.

“Indeed, these are exciting products that tell a great story, quite possibly giving you exposure to the next big trend. However, our research tells a very different story,” says Morningstar investment specialist Ian Tam.

“What our data shows is that the likelihood of these types of products surviving let alone outperforming a broad stock market index is extremely low. Over the past 15 years, more than three-fourths of thematic funds globally have shuttered and just one in 10 survived and outperformed.”

When you invest in a thematic fund, you’re making 3 bets:

  • That you’ve picked the right theme
  • The stocks that fit that theme aren’t already fully valued
  • That you’ve picked the right fund provider to execute investment in this theme.

"Though it’s true that the payout can be very high for these funds – the odds of success are very low," Tam says.

By the time you find out about a trend, it's often too late.