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Morningstar issues comprehensive research reports on ETF managed portfolio strategies and ETF tax efficiency


Morningstar has issued two research reports – the “ETF Managed Portfolios Landscape Report”, exploring current trends, asset growth, and the industry outlook for ETF managed portfolios, and, “ETFs Under the Microscope: Tax Efficiency Survey”, which investigates the claims of the tax efficiency of ETFs.

ETF managed portfolios are investment strategies that typically have more than half of their portfolio assets invested in exchange-traded funds. They are primarily available as separate accounts, and they represent one of the fastest-growing segments of the investment industry. In September 2011, Morningstar announced plans to research and rank ETF managed portfolios. The company is now tracking nearly 370 strategies from 95 firms through its separate account database with collective assets under advisement of approximately USD27 billion. As part of this effort, Morningstar has developed a proprietary portfolio attribute classification system based on its analysis of the ETF managed portfolio’s investment strategy as well as a historical review of disclosed holdings. Morningstar’s new system evaluates four main attributes: Universe (which looks at the starting scope of a strategy’s investment process on a global basis), Asset Breadth, Portfolio Implementation, and Primary ETF Exposure Type. The information is now available in Morningstar Direct(SM), the company’s web-based global investment analysis platform for institutional investors.

Andrew Gogerty (pictured), Morningstar’s ETF managed portfolios strategist and the author of the report, says: “As more investment professionals become familiar with ETF managed portfolio strategies, we expect demand for information to increase, and our goal is to provide the industry standard for classifying and comparing these strategies. By providing insight into a strategy’s attributes, we want to help advisors and institutional investors better understand the investment philosophy behind a particular strategy.”

In the ETF Managed Portfolios Landscape Report, Morningstar analysts evaluated the growth, assets, performance, categories, and other trends among the ETF managed portfolio strategies included in Morningstar’s database. The report found:

Total assets in ETF managed portfolio strategies rose by 43 percent in 2011;

The total amount of ETF managed portfolio strategy assets in the US is estimated to be between USD40 billion and USD100 billion when factoring in discretionary and non-discretionary assets and model portfolios;

The space is currently dominated by global strategies (defined as strategies where investors can gain exposure in any global market), which hold more than 72 percent of all ETF managed portfolio assets);

The subset of Global All-Asset strategies, which have the ability to invest in multiple asset classes, has captured more than half of the asset growth in ETF managed portfolios over the past year;

An important factor driving growth is the trend for financial advisors to outsource money management functions to firms specialising in ETF managed portfolio strategies, which allows advisors to focus on managing clients’ overall financial profiles.

Additionally, as a result of the changing distribution dynamics in the industry shown in the report, Morningstar plans to begin systematically collecting assets under advisement (AUA) for separate account strategies in 2012 to better capture assets following a given strategy.

In a separate report also released today, Morningstar examined the tax efficiency of ETFs by measuring the frequency of capital gains distributions of ETFs compared with indexed open-end mutual funds over the past five, 10, and 15-year periods. The report found that most ETFs are indeed tax-efficient compared with open-end funds, and the primary driver of ETFs’ tax efficiency is that most ETFs are passively managed index funds. ETFs also generate a smaller, but still significant tax savings from their structure–in the event of redemptions, ETFs help minimise taxable capital gains through the ability to exchange securities in-kind.

However, the report also found that tax efficiency is only one small component of after-tax performance: expense ratios, tracking error, index methodology, and replication methods may have an effect on returns that exceed any tax benefit. In addition, investor behaviour, including managing allocations and minimising turnover, are far more important than the tax structure of an investment vehicle when determining long-term performance.

Paul Justice, Morningstar’s director of ETF research, North America, says: “We wanted to test the tax efficiency claims that ETF providers have boasted about for years, and it turns out their claims are largely true. However, most passive mutual funds are extremely tax efficient as well, and when all efficiency factors outside of the tax question are put into play, we find that fund structure plays only a small role.”

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