The U.S. News Best Fit ETF rankings are designed to help long-term investors evaluate and compare the structure of exchange-traded funds. Since all ETFs are intended to track an underlying index (for a variety of equities, or the price of a commodity, for example), we aim to identify large, liquid funds that perform reliably and could function well as part of an investor's long-term asset allocation plan. We also compare funds' costs, both those contained in commonly published expense ratios and implied by trading spreads, as well as a fund's level of diversification and success in tracking its index. We discuss each of these measures in depth below.
The Best Fit methodology is divided into two components. The first is how the Best Fit ETFs are selected. The second is how funds are compared and ranked.
Selecting Best Fit ETFs
To identify Best Fit ETFs, we set criteria that we believe should be of interest to everyday long-term investors; namely, a fund's longevity, size, and appropriateness for a traditional asset allocation plan.
Our Best Fit ETF rankings include funds with at least a one-year trading history and at least $100 million in assets under management, and exclude funds using leveraged or inverse strategies, as well as actively managed funds. Such funds are fine for more sophisticated traders, but not long-term, passive investors. Funds meeting all of these criteria are designated "Best Fit" funds and are eligible to be ranked.
Note that only exchange-traded funds, and not exchange-traded notes, are included in the Best Fit ETF ranking.
Ranking Best Fit ETFs
Best Fit funds are ranked within their categories, such as Small Cap Funds or Municipal Debt Funds. Categorization of funds is provided by Interactive Data Corp.
Best Fit funds are ranked by an overall score calculated from four component measures: a fund's expense ratio, tracking error, bid/ask ratio, and diversification. For each component measure, funds receive a score between 0 and 100, based on their performance on that measure in comparison to other funds. The top-scoring fund within a given measure (lowest expense ratio, for example) receives a score of 100 for that measure. The four component scores are then weighted (see below) to create an overall score. The overall score defines a fund's rank within its category.
Components measures and their weightings:
• Expense Ratio (30%)
• Tracking Error (30%)
• Bid/Ask Ratio (20%)
• Diversification (20%)
Funds without data for the components outlined above are excluded from our ranking.
About the Component Measures
1. Expense Ratio
What is it?
Expense ratio is the percentage of fund assets a fund manager may withdraw each year to pay for operating expenses.
Why is it important?
Lower expense ratios mean better returns for comparable ETFs.
How is it measured?
Data is for a fund's total annual expense ratio.
2. Tracking Error
What is it?
Tracking error is a measure of the volatility of excess returns relative to a benchmark. Excess returns are the investment's return in excess of its primary benchmark, which is based on a broad asset class. The tracking error is calculated for the past six-month period. Benchmark indices are provided by Morningstar.
Why is it important?
Tracking error tells investors whether the ETF they've purchased is actually following the performance of its underlying index.
How is it measured?
Tracking error is calculated by a linear regression of the ETF's daily net asset value returns on the underlying index's daily total returns for the past six months.
3. Bid/Ask Ratio
What is it?
The bid/ask ratio measures the spreads between bid and ask prices among various ETFs. It is calculated by dividing the bid price minus the ask price (the "spread") for a fund by the mid price between the bid and ask prices.
Why is it important?
Bid/ask spreads can measure "hidden" transaction costs for an ETF, as well as liquidity (higher bid-ask spreads imply lower liquidity).
How is it measured?
The bid/ask measure is calculated daily and based on a 30-day average of closing bid/ask spreads. Narrower spreads receive higher scores.
4. Diversification
What is it?
Diversification in a fund is determined by two variables: the relative weight of the 10 largest holdings in a fund and the fund's turnover ratio, which is the rate at which a fund replaces its holdings on an annual basis.
Why is it important?
A greater diversity of weightings of a fund's constituents provides better diversification when comparing funds, and reduces the likelihood of a few large holdings dragging down a fund's overall performance. At the same time, higher fund turnover can lead to higher costs for owning a fund, and turnover in index funds should generally be low, which is why we've included turnover in our fund rankings. While this measure gives a slight edge to equity funds, its lower weighting in the overall rank means low costs and great index tracking ability will be the largest determinants of fund rank.
How is it measured?
There are two components used to measure diversification: the overall weight of the fund's 10 largest holdings and the published annual turnover ratio for each fund. Each component receives a 10 percent weighting to determine the total 20 percent weighting for diversification in the overall rank.
Additional Data Information
Fund data are provided by Interactive Data Corp. and Morningstar Inc. ETF metrics and rankings are updated daily.
About our Best Fit Scorecard
Our Best Fit Scorecard, provided for all funds meeting the Best Fit criteria (see above), offers a comparison across all categories of Best Fit funds to highlight how funds compare to a wider selection of funds in Cost, Tracking Error, Bid/Ask Ratios, and Holdings Diversity (see above for discussion of how we determine those measures). Funds receive overall scores in each category, with the lowest third of scores receiving designation of "Typical", the middle third "Good", and the top third "Excellent".
Disclaimer
Data, rankings, and scores provided for U.S. News Best Fit ETFs are provided for informational purposes only. They do not constitute any recommendation to buy or sell any fund and are not intended to be a substitute for professional advice. Always seek the advice of a relevant professional with any questions you may have about any financial decision you are seeking to make.
If you have additional questions about US News Best Fit ETFs, please contact us.
Reader Comments Read all comments (2)
John Hancock of MT 4:16PM December 05, 2011
BC of CO 11:18AM November 29, 2011