Fundamental Research for ETFs & Mutual Funds: Look Out Morningstar

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Ever wondered what it would be like to evaluate funds with the same rigor that you can evaluate individual stocks – that is exactly what we deliver in our new fundamental research for ETFs/funds product.

Historically, fund or ETF ratings have relied almost entirely on the past price performance or other purely technical data for their rankings. I don’t think that past price performance or tracking error is any more indicative of future price performance for groups of stocks (i.e. ETFs and funds, etc) than it is for individual stocks. Accordingly, we developed the first-ever fundamental research for ETFs and mutual funds; so investors can apply as much rigor to their assessment of ETFS/funds as they do individual stocks.

Our first mutual fund rating report was on Legg Mason Cap Mgmt Value Trust (LMVTX). You can view an abridged, free version of the report by clicking here.

This report provides better analysis than traditional fund/ETF ratings by focusing on the earnings quality and valuation of current holdings as opposed to historical price performance of the overall fund.

We recommend investors buy an S&P500 ETF/Index fund rather than LMVTX, which offers less upside at a higher cost. There is no reason for investors to pay LMVTX’s 1.69% total expense ratio while the SPY, the most common S&P 500 ETF, has a total expense ratio of only 0.09%.

As detailed in the report, LMVTX is a much more expensive and less attractive version of the S&P 500.  This conclusion is based on analyzing the Risk/Reward Ratings for all the companies in LMVTX. We found that the fund LMVTX allocates 70% of its value to stocks with a Neutral Rating or worse. The S&P 500 only allocates 55%.

We have published reports on all sector ETFs. Click here for our Sector ETF Roadmap report, which details our Risk/Reward ratings on all sectors. There is only one Attractive-rated sectors and 4 Dangerous-rated sector.

This research on funds and ETFs offers a new and unique approach to help investors assess the merit of investing in mutual funds and ETFs. We apply the same rigorous analysis to the group of stocks in LMVTX as we do to individual stocks.

Given the success of our Rating system for individual stocks, we believe its application to groups of stocks (i.e. ETFs and funds) will also help investors make more informed decisions.

Methodology: Fundamental Research for Mutual Funds and ETFs

Our analysis of Legg Mason Capital Management Value Trust (LMVTX) is based on the aggregation of data for 43 of the 44 companies in LMVTX weighted according to the fund’s holdings as of November 15th, 2010.  See Figure 5 for a complete list of companies, their weights in the fund, and their ratings.

Our analysis of Sector ETFs is based on all companies in those sectors on a market-weighted basis.

This report offers benchmarks for (1) investors considering buying LMVTX and for (2) comparing other mutual funds to LMVTX.

1 Comment

  • Trustamind

    April 23, 2011

    Actually recently I got a similar idea to rank ETFs. I developed a fundamental ranking system to rank stocks and I was able to show that the ranks of stocks drive their short term (1 week to 6 week) returns. But it is hard to trade the system for a couple of reasons:

    1. If I pick only a few top ranked stocks, there may not be enough liquidity as some stocks are thinly traded.
    2. If I pick a portfolio, then managing it would be a problem, and it will have high turnover and the trading cost would be high because I’m doing weekly rebalance.

    Then this idea popped up when I was discussing with a value investor on an irrelevant topic. I can use my ranking system to rank ETFs and trade the top ranked ETFs. The rank of an ETF is the weighted average of ranks of stocks in its portfolio. This will resolve the two problem at the same time. With some preliminary data I could show that there is a linear relation between the ranks of the 9 popular SPDR ETFs and their 1 week return.

    I’m very interested in what you are doing here and I do have a couple of questions:

    1. How stable are the ranks of ETFs. If we look at the top k ranked ETFs overtime, how likely we see changes in this group and how often we may see such change.
    2. I suppose you’ve applied your ranking on a broad number of ETFs (not like me only tried the 9 SPDR sector ETFs). Among them, who is most likely to receive top ranks? Be it index tracking ETF, sector ETF, ETF for special industry, or else? How liquid are those top ranked ETFs and how large is their bid / ask spread?

    Thanks a lot!

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