How We Rate ETF and Mutual Fund Holdings
The Portfolio Management Rating of an ETF or a fund is based on the aggregated stock ratings of the securities it holds as well as its overall Asset Allocation rating. The Portfolio Management Ratings and the Total Annual Costs ratings combine to determine our Predictive Fund Ratings. New Constructs’ stock ratings are regularly featured as among the best by Barron’s over the past three years. Figure 1 displays the criteria and thresholds that go into the Portfolio Management Rating of every ETF, mutual fund or portfolio we cover. Note that the Portfolio Management Rating is the same as a stock rating except that it incorporates our rating on the fund’s Asset Allocation.
Figure 1: Portfolio Management Rating Table
Sources: New Constructs, LLC
New Constructs’ ratings on the stocks held by funds are aggregated according to the allocation the fund makes to each stock. The aggregated ratings of the holdings translate into the Portfolio Management rating of the ETF, mutual fund or other portfolio. Below is a summary of the criteria that drive the Portfolio Management rating. We assign ratings to every stock under coverage according to what we believe are the 5 most important criteria for assessing the risk versus reward of stocks. Those criteria are divided into two categories: “Business Strength” and “Valuation”.
1) Business Strength: the quality of the economic earnings of the company and the strength of its business model based on its ROIC.
a) Quality of Earnings measures how reported accounting income compares to the economic earnings of the stocks in the fund.
b) Return on Invested Capital (ROIC) measures the aggregate cash on cash returns of all stocks in the fund.
2) Valuation: based on the expectations embedded in stock prices. Investors should buy stocks/funds with low expectations.
a) Free Cash Flow Yield measures the true cash yield of the companies held by the fund.
b) Price to Economic Book Value measures the growth expectations embedded in the prices of the stocks in the fund.
c) Market-Implied Duration of Growth (Growth Appreciation Period) measures the number of years of future profit growth required to justify the current valuation of the stocks in the fund.
3) Asset Allocation: The Asset Allocation Rating informs investors of each fund’s level of allocation to cash (non-equities) as well as how that level compares to other equity funds. We assume investors in equity funds prefer those funds to be maximally invested in equities given that investors can much more cheaply invest in cash on their own. We do not believe that most investors want to pay the fees associated with equity funds to invest in cash.
a) Cash Allocation measures the percent of the fund’s assets allocated to cash.