Exchange-traded funds are a low-cost way to invest. They provide easy access to a variety of asset classes, and unlike traditional funds, trade just like a stock on the exchange so you can purchase one with an online broker.

Today, there are over 200 ETFs listed on the ASX. There are ETFs that give you exposure broad market indexes, while others offer exposure to niche sectors such as cybersecurity. ETFs now also offer exposures to a variety of investment strategies such as active management and smart beta.

With so many ETFs choose from, how do you know which is the best for your portfolio?

In the third article in our Investing Basics series on ETFs, we'll explore how Morningstar Analyst Ratings can help you identify top-notch ETFs in every asset class.

More in this series:
Investing basics: what is an ETF?
Investing basics: the pros and cons of ETFs

How Morningstar rates ETFs

Morningstar analysts evaluate over 70 ETFs trading on the ASX and identify those they think will be able to outperform in years to come. This includes ETFs from the five largest product providers in Australia (by total net assets - at 09-2019): Vanguard Investments Australia, iShares, BetaShares Capital, State Street Global Advisors (AUS) and VanEck Investments. Analysts also cover Active ETFs from providers AMP Capital, Magellan, Schroders, and Antipodes.

Costs – explicit costs like the expense ratio, and implicit costs like the cost of portfolio turnover – are paramount in running an index fund. Top-rated funds are among the lowest cost options in their category, relative to their actively and passively managed peers.

But costs are just one component of Morningstar's assessment of ETFs. Analysts scrutinise their performance relative to others in the category, both active and passive.

For passive products, analysts examine the fund's process – that is how the ETF are constructed, their underlying benchmarks, and the systems managers have put in place to achieve precise tracking of the benchmark.

Analysts also tend to favour parent firms that put investors' interest ahead of commercial goals, and monitor how the ETF is trading on the exchange. ETFs sometimes trade with wider than normal bid/ask spreads, or deviate substantially from their net asset value, or NAV, which can jack up the cost to investors.

Other issues considered by analysts:

  • The amount of experience the team has in managing ETFs
  • Rules dictating the balancing and reconstruction of the fund's benchmark
  • Portfolio management approach – for examples full or synthetic replication
  • Tracking issues that might arise
  • How portfolio managers attempt to minimise trading costs
  • The fund's distribution policy
  • Firm's overall levels of transparency
  • Firm's product development philosophy and its track record of launching new funds and shuttering unsuccessful ones

Medallist ratings are reserved for funds that analysts expect to deliver precise tracking of sensibly constructed indexes at a very low cost and backed by experienced managers. ETFs that analysts expect to outperform by the widest margin are rated Gold; next-highest conviction picks are rated Silver, followed by Bronze.

Medals are accompanied by the “analysts take” on the ETF – which includes their views on its suitability for investors, portfolio construction, fee and alternatives to consider.

Gold rated ASX listed ETFs

Moringsta gold etfs

Source: Morningstar Direct

Click to see the full list of:

Analysing smart beta and active strategies

Morningstar rates ETFs that fall under the heading of strategic- or smart-beta - to a different standard. Morningstar director of investor education Karen Wallace explains that Morningstar analysts think of strategic-beta ETFs as index funds that make active bets.

"They are linked to indexes that focus on one or more factors - such as value, momentum, or low volatility, in an effort to improve their returns or alter their risk profiles relative to traditional market benchmarks," she says.

"Because of this, they require strategic-beta funds to surpass a tougher hurdle: They need to convince us they can beat the category index after fees (not the median fund in the category). Our assessment of process is the most important consideration behind the rating for these funds."

Morningstar also assigns ratings to several actively managed ETFs.

"We put these funds through the same paces as we do actively managed mutual funds, while paying close attention to how the potential constraints of delivering an active strategy in the ETF format might affect the management team's process," Wallace says.

Use the Morningstar ETF screener to find the best ETFs

Morningstar ETF screener

Morningstar's new Premium website helps filter the universe of over 200 Australian ETFs to discover Morningstar's top-rated ETFs. By using the Prem Icon ETF Screener tool, you can quickly compile and save a list of Gold, Silver and Bronze-rated ETFs across several asset classes.

You can screen by the following criteria:

  • Fund management company
  • Asset class
  • Management style (active or passive)
  • Morningstar analyst rating
  • Dividend yield
  • Management fee
  • Total return