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For all the extraordinary innovation occurring in ETFs, no standardized ratings exist to help everyday investors sort through the rapidly growing number of ETF options.  The most recent poster child of the problem this creates is the VelocityShares Daily Inverse VIX Short Term ETN (XIV), which went to zero during early February’s unprecedented spike in stock market volatility.

Source:  MoneyWeek

 

Here’s the issue:  this product functioned exactly the way it was supposed to, yet some investors were caught completely off guard.  This raises several important questions:

-> Did every XIV investor understand the risks involved?  (we know the answer to this one: no)

-> If XIV came with some sort of a rating or warning label, would that have saved at least some unwitting investors from getting burned?  (we know the answer to this one too:  yes)

-> What if ETFs were required to provide key data points to investors in the same manner that the FDA requires a nutrition facts label for food?  Perhaps the label would include expense ratio, weighting methodology, concentration of holdings, trading spreads, use of leverage, etc.  Would that help solve the problem? (answer:  maybe?)

Now, some would argue an ETF’s Fact Sheet (example here) diligently serves this purpose.  But should there be an easier way for everyday investors to quickly identify ETFs posing greater risks?

Bloomberg’s Eric Balchunas has been raising awareness around this issue for several years.  Eric only somewhat jokingly proposed that maybe we should classify ETFs using the movie rating system.  For example, a plain-Vanilla S&P 500 ETF would be rated “G” and the above Velocity Shares Inverse VIX ETN would get slapped with “NC-17”.  From Eric’s highly-recommended book, The Institutional ETF Toolbox:

“While movie ratings look at the levels of things such as violence, nudity, and drug use, my rating system looks at the levels and complexities of the holdings, structure, fees, weightings, and taxation. Basically, it flags all the little bugaboos that can equate to a surprise or bad experience and then adds them together to determine a rating. Perhaps this is more appropriate for a retail audience, but I think given the avalanche of new complex products, anyone doing ETF investing could benefit from it.”

Pretty straightforward.  If your 13-year old wants to watch a rated “R” movie, there’s a good chance you’ll spend a few minutes digging into what’s driving the rating.  There’s probably no shot you’ll let your 8-year old watch a rated “R” movie.  This could be useful in ETFs, essentially red-flagging some ETFs, while green-lighting others.  Speaking of green lights, more recently, Eric has spearheaded a simple traffic light system for ETFs on the Bloomberg Terminal:

Clearly, the idea with both of these is to offer a quick, first glance appraisal of an ETF.  Obviously, additional homework is required.

There are other ETF rating systems, some more in-depth.  ETF.com offers one of the most helpful (and free) resources to kick the tires on any ETF.  If you type “etf.com/” followed by an ETF ticker symbol into your browser (for example, etf.com/vti), you’ll immediately have access to a treasure trove of data, including a three-tiered rating system.  ETF.com uses letter grades (“A” through “F”) and a numerical ETF “Fit” score, which together covers everything from how well an ETF accomplishes its goals to tradability to tracking error and cost.  Top ETFs in each market segment also receive an “Analyst Pick” designation.

 

Morningstar provides their well-known “star” rating system for some ETFs.  This is a backward-looking measure of an ETF’s past risk and cost-adjusted performance.

 

Morningstar also offers forward-looking “Analyst Ratings” for a number of ETFs.  A rating of Gold, Silver, Bronze, Neutral, or Negative is assigned to an ETF with the idea being to express Morningstar analysts’ assessment of how well it will perform versus its category peers moving forward.  ETFs are rated based on five pillars – People, Process, Performance, Parent, and Price – taking into account factors such as index construction methodology, all-in costs, performance and tracking error, the portfolio management team, and the ETF provider.

 

CFRA is another research shop offering in-depth, forward-looking ETF ratings which are updated on a daily basis. They utilize a three-tiered ranking system of “Overweight”, “Market Neutral”, or “Underweight”.

 

There are other tools available to help gauge ETFs including measurements of active share and a “smart beta” spectrum depicting the level of factor exposure in an ETF (this is another tool championed by Bloomberg’s Eric Balchunas and one which has colorfully been compared to showing the alcohol content in beer).

 

There are plenty of ETF resources out there.  The challenge for everyday investors is accessibility and standardization.  Most of the above ratings are behind paywalls.  These ratings are much more likely to be seen and used by professional investors.  In some cases, only a fraction of the ETFs are even rated.  Also, different ratings mean different things to different people.

This is a problem for both investors and the ETF industry.  ETFs have democratized investing, leveling the playing field by bringing institutional-caliber strategies to the masses.  That’s great.  But when investors have bad experiences, even when products function as intended, the ETF industry suffers a perception problem.  How many ETF scare pieces include references to leveraged or inverse products?

At a basic level, just labeling broad product categories differently might help some investors avoid disaster.  BlackRock, who offers the world’s largest ETF lineup, issued a statement after several inverse products – including XIV – experienced sharp declines on February 5th:

“BlackRock strongly supports a regulatory classification system that would label levered and inverse ETPs differently than plain-vanilla ETFs in order to clarify for both regulators and investors the risks associated with those products.”

I think that’s a step in the right direction.  Several brokerages have also taken positive steps, providing warnings to investors prior to allowing them trade execution in riskier ETFs.  Still, it seems greater accessibility and standardization of ETF ratings would go a long way towards helping protect and educate investors, while further solidifying the ETF industry as the forward-thinking and transparent business that it is.  I don’t claim to have all of the answers and standardization/greater regulation no doubt presents its own challenges.  At the end of the day, every investor has a responsibility to do their own homework.  The golden rule of investing is “if you don’t understand it, don’t invest in it”.