With the Canadian mutual fund business continuing to cede ground to ETFs, investors have a new tool in judging one against the other.
Morningstar has begun to assign analyst ratings to individual exchange-traded funds by applying the same methodology it already uses to evaluate mutual funds and individual stocks.
While qualitative ETF research and recommendations are certainly not new, Morningstar said its system is the first of its kind in its methodology and its scope to be made available to Canadian investors.
"We have our own broad research base and we can go through a list of ETFs and find the one we like the best. But the average investor may not have a clue," said David Cockfield, managing director and portfolio manager, Northland Wealth Management.
The dominance of the mutual fund in Canada is still far from being compromised. With more than $1-trillion in assets, the older fund business still dwarfs its newer counterpart by at least a factor of 10.
But the share of the market claimed by ETFs is rising. And growing awareness of high fees as killers of long-term portfolio returns has shifted investor perceptions.
Investors have increasingly begun to favour passive investing through exposure to broad indexes – a style that is facilitated by low-cost index ETFs.
"Investors increasingly make no distinction between mutual funds and exchange-traded funds," Christopher Davis, director of research at Morningstar Canada, said in a report. "As substitutes, investors should compare the vehicle types against each other."
By applying a common method to both arenas, Morningstar said its new ETF ratings can help investors do that. That methodology assesses the long-term prospects of individual funds by scoring them on five criteria: people, process, performance, parent organization and price. That analysis distills into a rating scale of gold, silver, bronze, neutral or negative.
The initial batch of ratings focuses on "lower-cost portfolio-builders," resulting in an overall favourable skew. Of the 37 Canadian ETFs, 28 of them, or 76 per cent, got positive ratings.
"Had we included high-priced niche ETFs, such as those that provide leveraged market exposure, you'd see a higher proportion of neutral or negative-rated funds," the report said. The ratings system will soon be applied to a broader swath of the ETF space, Mr. Davis said.
The highest overall ratings were applied to broad Canadian equity funds (tickers: XIC, VCN, VCE), and U.S. equity funds (tickers: XUS, VFV, VUN) offered by Vanguard and iShares. Vanguard's Canadian short-term bond fund, VSB, also got a "gold" rating.
There's a reason the top ratings lean toward equities over fixed income, the report said.
Active Canadian fixed-income managers differentiate from the broad market benchmark by investing more heavily in corporate bonds, and some high-yield. Canadian bond ETFs tend to track conservative indexes heavily weighted in government bonds.
"These distinctions make price a less-reliable predictor and open a window, however small, for active managers to outperform," Mr. Davis wrote.
The same can't be said for funds tracking broad stock indexes. "Active Canadian large-cap managers don't venture much, if at all, from this sandbox," he said.