ETF Ratings, Feh

Tom Lydon a post up questioning the utility of ETF ratings as put forth by S&P (and to a lesser extent Morningstar). According to Tom's post S&P makes recommendations about overweighting or underweighting ETFs based on "a number of factors, including S&P’s research into the fund’s underlying holdings."

Over the years I have been very critical of Morningstar for analyzing ETFs from the bottom up using their value bias. The way Tom's post reads this is a new thing for S&P and there are comments from other advisors in this article about the same thing. I don't really agree with what the other advisors are saying either, well what I think they are saying anyway.

ETFs, the simple ones, are just exposure. Anyone looking to add industrial exposure to their portfolio has quite a few industrial sector funds to choose from along with some specialty funds that are heavy in industrial companies; for example the PowerShares Aerospace and Defense Portfolio (PPA) is very heavy in industrial stocks.

If you wanted to capture a theme or add more volatility you would probably look at one of the specialty ETFs to be part of the mix and if you were less certain about the near term prospects you might go with one of the mega cap sector funds like the Utility Sector SPDR (XLI). All of these funds offer exposure. If the market tanks does it matter that based on earnings estimates or reported earnings or whatever that the largest five stocks look attractive so the fund is attractive?

Conversely if the fundamentals look lousy and the market skyrockets what do you think the ETF will do? The financial sector SPDR is up 75% off the March low, anyone think that is a fundamental story? In a bear market these ratings will be correct for every fund the don't like and be wrong for every fund they do like. The opposite will be true in a bull market. This is not very useful. I will say that if a fund has 15-20% in one stock you should probably know a little about that stock.

Reading through the above it makes the case for top down portfolio construction but there are bottom up applications too, just not the way S&P and Morningstar do it. If someone wants exposure to the solar group for whatever reason their choices are to buy a stock (or a few stocks) or a fund of some sort. The way in would just depend on the person but the way this is framed it is about a person wanting solar. Regardless of the ratings from anyone, if oil goes up 50% the TAN ETF will skyrocket, that fund went from about $5 in March to $11.50 in mid June. Now oil has corrected some and TAN is trading down in the eights. Valuation of the underlying stocks are way down on the list of what matters here.

An ETF is just an exposure. The reasons for wanting that exposure are either correct or not and the timing is either correct or not. In selecting between funds things like foreign exposure, cap size (comes into play when considering a specialized fund), volatility, subsector all come into play in terms of picking the best fund for you. I've written about how I go about that many times if you are so inclined to search for it in the archives.