Exchange-traded funds have been around for over a decade, but their growth in the past few years has attracted even the attention of outside rating services.The ETF channel now numbers over 200 funds with an aggregate $300 billion in assets. The growth in the marketplace gives advisors access to sectors in new ways that help maximize client service.

The breadth of offerings puts an ETF in every pot. Every major index is represented, as well as slices of the biggest asset classes, like iShares Russell 1000, as well as individual growth and value splits of the same index. Advisors also look to ETFs to fill in niches. Indexes such as SPDR Homebuilders or iShares Nasdaq Biotechnology give investors access to very specific markets.

"Most of the time, ETFs bring total participation in a sector," says Irvin F. Diamond, CPA/PFS and CFP, of Business and Financial Resources LLC, in Albuquerque, N.M. "But we now can use ETFs on a rifle-shot basis when a client has an interest in a particular niche."

There are increasing opportunities for advisors to add work with niches.

State Street Global Advisors Inc. recently announced the launch of 17 ETFs, 15 of which invest in very narrow sectors. This allows advisors to tailor client portfolios in several ways. A client wanting to add weight in niches such as energy or natural resources can increase that slice with the lower cost and greater tax efficiency of ETFs. The availability of multiple slices within a larger asset class allows advisors to help clients balance out concentrated positions in one slice of the sector.

"The ETFs are less risky than owning a single stock in the sector, and far cheaper than buying the regular mutual funds," said Diamond.

Let the ratings begin

The growth and age of the industry has attracted outside evaluation. "A couple of years ago, it seemed that ETFs were an idea whose time had come and they began springing up everywhere," Diamond said. "But up until the last six months, we had no real independent evaluation of their effectiveness or internal costs."

That changed this March, when Morningstar introduced star ratings on 107 ETFs. ETFs are evaluated within the assigned Morningstar categories, alongside their traditional open-end counterparts. "We needed to wait until enough ETFs had three-year performance histories before adding this service," says Dan Culloton, lead analyst on ETFs for Morningstar.

Morningstar's stars are the latest service relating to ETFs. The Chicago-based company provides analysis of ETFs and the industry. Two years ago, the company licensed its style-based indexes to iShares Trust for iShares Morningstar ETFs.

The ETF star ratings are based on the same mathematical formula used for open-ended funds. The rankings are based on the net asset value of the ETFs, not the market price. Prices are adjusted for estimated commissions by a total of 40 basis points. Then the ETFs are ranked within the best size and style categories. "For lots of people, ETFs are not an either/or proposition, but are evaluated against open-end funds or individual stocks," says Culloton. "After all, ETFs are just open-end mutual funds that trade on an exchange."

The ratings can be less useful for niche ETFs. Some very small indexes don't have their own category, so they get put into more general groups. For example, the PowerShares Lux Nanotech gets placed in with other specialty technology and country-specific funds like Brazil and Korea, and gets ranked against all emerging markets. "The star ratings of niche funds are likely to be more volatile," said Culloton. "On occasion, they may look exaggerated compared to the category, and you'll have to take them with a grain of salt."

The star ratings of any ETF should be useless, according to Benjamin Tobias, CFP, CPA and CIMA, of Tobias Financial Advisors, in Ft. Lauderdale, Fla. Tobias uses ETFs extensively in all asset classes because of the benefits of low cost, tax efficiency and flexibility. "The bigger ETFs should all have a rating of three stars," says Tobias. "They're the low-cost index, which means they inherently rank slightly above average in the category."

The iShares Russell 2000 Value and iShares Russell 2000 Growth 3 bear out the theory, with a rating of three stars each. But by some anomaly, the combined iShares Russell 2000 Index sported only two stars. The difficulties of ranking the niche ETFs proved out in the spread between the four stars of the iShares MSCI South Korea Index Fund and the two stars earned by the Singapore Fund from the same issuer. "Both of these are in the emerging market category, but it's like comparing apples to oranges," says Tobias. "The star ratings might even open Morningstar to some criticism about its evaluation system."

New offerings

Continued expansion in the types and numbers of offerings holds great appeal to advisors. "I'm real happy that they've added a commodity ETF, and I'm going to jump into it when the time in the cycle is right," Tobias said.

Several ETFs in gold and natural resources were joined in January by the Deutsche Bank Commodity Index ETF.

Still on the docket are actively managed ETFs. Several issuers have offerings with tactical strategies that trade based on market movements, such as PowerShares Zacks Small Cap Portfolio. This fund buys small cap stocks after certain kinds of positive earnings surprises, and changes in the index are made as often as once per week. "It's hard to say when or if actively managed funds will ever win regulator's approval," said Culloton. "They might just prove out to be more expensive, less tax-efficient ETFs that would underperform the benchmarks."

Diamond reported that recently, the head of the firm's investment committee set out to determine the full scope of what's available in the ETF marketplace.

"As a practical matter," he said, "if the investor is someone who likes to buy and hold various sectors, ETFs look like a very inexpensive way to accomplish those goals."

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