Sonya Morris, an ETF writer for Morningstar wrote an article called “How To Evaluate New ETFs.” Like most of what I have ever read by her, I think takes the wrong approach to ETF selection. It seems that Morningstar tries to apply bottoms up analysis to ETFs and I don’t think this makes any sense.

Anyone building a portfolio with ETFs (or other types of funds) is specifically not picking stocks. They are either making decisions about the broad market, cap size, style, sector, countries or some combination of the above which I think are more forward looking than bottom up analysis which looks at whether a stock is reasonably valued or not and then assuming that if it is fairly valued it will do well. This makes a lot more sense for a stock than for something like mid cap growth. In her article she picks on some of the new emerging market ETFs from StateStreet because…

Emerging-markets funds have notched double-digit returns for several years now, and it’s hard to see them continuing at the same breakneck pace. Plus, the strong rally has pushed emerging-markets valuations to pricey levels, according to Morningstar’s international stock analysts.It wouldn’t be surprising to see that market segment cool, which would clearly be an unfavorable development for the new ETFs.

So is she saying investors should have zero in emerging markets? The article never clarifies so we can’t know. Emerging markets is a segment of the market. Anyone interested in a diversified portfolio should always have some exposure. At any point in time there should be more or less exposure based on some of the things she mentions but to be clear she should be using those points as reasons for adjusting how much not deciding if.

She questions the timing of SPDR S&P Emerging Markets (GMM) for the reasons stated above. This is the wrong way to look at it. The big point of differentiation with GMM is no South Korea. This will make GMM more attractive more attractive for some people over something like iShares Emerging Market EEM which is heaviest in South Korea.

I think the process needs to be more like do you want to be heavy or light in emerging markets? Then based on various big picture things important to you, what parts of emerging markets do you think are best; commodity based, frontier, manufacturing based and so on? Once that is decided, what is the best way for you to access emerging; broad-based, narrow-based (which includes individual stocks) or some combination of both? Then finally the individual picks.

If you want a broad-based but don’t want South Korea then GMM becomes your only choice making the analysis in the article moot.

Another misguided bit of insight is the poo-poohing of the PowerShares DWA Technical Leaders Fund (PDP). Ms. Morris notes that “PDP doesn’t look compelling right now from a valuation perspective.” She further goes on to note that PDP “smacks of performance chasing, and it completely ignores valuation, which is a core tenet of my investment philosophy. A look at this ETF’s price characteristics confirms that valuation is not paramount here.”

Are you kidding me?

I have not studied PDP but I am thinking that a fund called Technical Leaders probably employs some sort of technical analysis as opposed to the bottoms up that Morningstar believes in. Further we might glean that PDP does exactly what she says; chases performance and ignores valuation. On some level isn’t that exactly what technical analysis is? PDP may or not be a good fund but she is essentially saying “I don’t like technical analysis because I don’t like technical analysis.”

I continue to hope that Morningstar can deliver useful ETF content, but it hasn’t happened yet.

Last 5 posts by Roger Nusbaum

• Headed To Hilo - November 19th, 2008
• Throwing In The Towel - November 18th, 2008
• Closing Bell - November 17th, 2008
• Something Will Have To Give - November 17th, 2008
• Random Roger's Big Picture 2008-11-16 13:19:00 - November 16th, 2008