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Home > Asset Management Best Practice > The Ability of Ratings to Predict the Performance of Exchange-Traded Funds

Asset Management Best Practice

The Ability of Ratings to Predict the Performance of Exchange-Traded Funds

by Gerasimos G. Rompotis

Executive Summary

  • Rating of the past performance of securities is considered crucial by investors when they make investment decisions.

  • Several rating methods are used in the financial literature and by the investing community to rate the performance of securities.

  • Performance is considered to be in some way predictable, and prediction is based on past performance.

  • This article empirically assesses the rating of exchange-traded funds (ETFs) and prediction of their performance.

  • The methods examined are the Morningstar rating process, the excess return, the Sharpe ratio, and the Treynor ratio.

  • The empirical results reveal a high consistency among the rating methods and a sufficient level of predictability of ETF performance.

  • ETF performance is persistent over the short term.

Introduction

Exchange-traded funds, or ETFs, are a relatively new investment product, but they are very important for both institutional and retail investors. ETFs are hybrids of ordinary corporate stocks and open-ended mutual funds which invest in baskets of shares that closely replicate the performance and risk levels of specific broad sector and international indexes. As such, ETFs offer investors a considerable level of risk diversification with just a single transaction. The risk of investing in ETFs can be moderated by choosing non-equity investments such as corporate bonds or treasury bonds, both of which are less risky choices than the most common equity-linked ETFs. Also, fixed-income ETFs, which usually carry low risk, are available for investors along with commodity and real estate ETFs.

ETFs are cheap investment tools because their administrative costs are low. This is reflected in low expense ratios due to their passive investment character, which requires managers simply to follow the tracking indexes and not to develop complicated and high-cost investment strategies. Nevertheless, it should be borne in mind that extremely frequent trading can offset the benefits of low expense ratios. The level of ETF expense ratios varies. In particular, ETFs that track broadly diversified indexes have the lowest expenses, followed by those that track sector indexes and others which invest in international indexes. Beyond managerial costs, ETFs pay commission to brokerage companies.

ETFs provide significant trading flexibility since they offer continuous pricing and the ability to trade throughout the day, unlike most mutual funds, which are traded at the end of the day. Furthermore, ETFs offer opportunities for the implementation of both passive and active trading strategies. The most common investment strategy in ETFs is the passive buy-and-hold strategy, the return of which depends exclusively on market performance. Also, ETFs allow active intraday trading and enable investors to buy and sell, in essence, all of the securities that make up an entire market with a single trade. They therefore provide the flexibility to get into or out of a position at any time throughout the day.

Another significant element of ETFs is the potential for high tax efficiency that they offer, since they tend to generate fewer capital gains than traditional mutual funds. The tax efficiency of ETFs arises from their discrete “in kind” creation/redemption process. ETFs are created in block-sized units of 25,000, 50,000, or 100,000 shares by large investors and institutions. The creator of an ETF purchases and deposits with a trustee a portfolio of stocks that approximates the composition of a specific index. In return for this deposit, the creator receives a fixed number of ETF shares, all of which are then usually traded on a secondary exchange market. The redemption of ETFs follows the reverse direction. Buying and selling of ETF shares usually takes place among shareholders and, as a result, there is no need for the ETF to sell its assets to meet redemptions. This advantageous feature of ETFs restricts the realization of taxable capital gains.

The trading price of ETFs usually deviates from their corresponding net asset value, providing arbitrage opportunities for big investors. If the value of the underlying portfolio of stocks is greater than the ETF price, the institutional investor will redeem the low-priced units of ETF by receiving the high-priced securities. In contrast, if the value of the underlying stocks is lower than the ETF price, the investor will exchange the low-priced securities for a newly created unit of the ETF.

Finally, ETFs are characterized by large liquidity, which contributes to easy and rapid trading near their fair market value and to the narrowness of bid/ask spreads and volatility. The liquidity of an ETF is not related to its daily trading volume but rather to the liquidity of the stocks contained in the index. The high liquidity of ETFs is achieved due to the ability of market-makers, which are usually large brokerage houses, to create and redeem shares of ETFs perpetually in response to market demand.

Because of their success, ETFs have begun to attract significant interest in the finance literature. An issue that so far has not been thoroughly examined is the rating of ETF performance and the ability of ratings to predict future performance. Nevertheless, several companies provide ranking services. The most popular is Morningstar, Inc., which rates ETFs on a scale of one to five stars according to past performance. Here we provide an introduction to ETF performance rating by investigating whether ratings are indicative of future returns. We do so using a sample of 50 Barclays iShares.

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Further reading

Articles:

  • Blake, Christopher R., and Matthew R. Morey. “Morningstar ratings and mutual fund performance.” Journal of Financial and Quantitative Analysis 35:3 (September 2000): 451–483. Online at: dx.doi.org/10.2307/2676213
  • Blume, Marshall E. “An anatomy of Morningstar ratings.” Financial Analysts Journal 54:2 (March/April 1998): 19–27. Online at: dx.doi.org/10.2469/faj.v54.n2.2162
  • Khorana, Ajay, and Edward Nelling. “The determinants and predictive ability of mutual fund ratings.” Journal of Investing 7:3 (Fall 1998): 61–66. Online at: dx.doi.org/10.3905/joi.1998.408470

Reports:

  • Sharpe, William F. “Morningstar’s risk-adjusted ratings.” Working paper. January 1998. Online at: www.stanford.edu/~wfsharpe/art/msrar/msrar.htm
  • Wermers, Russ. “Is money really ‘smart’? New evidence on the relation between mutual fund flows, manager behavior, and performance persistence.” Working paper. November 2003. Online at: ssrn.com/abstract=414420

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