Morningstar Rating - ETFs

Note: The Morningstar Rating for Exchange-Traded Funds will be rolled out on March 1, 2006.

The Morningstar Rating for exchange-traded funds, commonly called the star rating, is a measure of an ETF's risk-adjusted return, relative to open-end funds in the same category. ETFs are rated from one to five stars, with the best performers receiving five stars and the worst performers receiving a single star.

The Morningstar Rating for ETFs is based on the same methodology as the Morningstar Rating for open-end funds. Morningstar first calculates risk-adjusted return for each ETF for the three-, five-, and 10-year time periods by adjusting total return for sales charges, the risk-free rate, and risk. Morningstar then compares each ETF’s risk-adjusted return to the open-end rating breakpoints for that category. The overall rating for an ETF is based on a weighted average of the time-period ratings.

Additional Detail:

Morningstar starts with an ETF’s total return and then adjusts that for sales charges, the risk-free rate, and risk to determine its risk-adjusted return.

Most exchange-traded funds have both market prices and net asset values (NAVs). Morningstar will use returns based on NAVs for the ETF rating. This approach allows us to capture the manager’s performance independent of market sentiment or stale prices.

Most investors purchase and sell ETFs on a stock exchange, so Morningstar uses a 0.2% front load and a 0.2% deferred load in the rating methodology to represent the commission on those trades. This represents our estimate of the average commission paid ($20) and the average investment amount ($10,000) for an ETF purchase. The effects of the sales charges are spread over three, five, and 10 years for each time period rating, respectively.

After the adjustment for sales charges, Morningstar measures the ETF’s excess return over the risk-free rate.

The risk adjustment in Morningstar’s rating methodology is based on expected utility theory. We measure the amount of variation in the ETF's monthly returns and give greater penalties for downside variation.

Because ETFs are a fairly small investment universe, Morningstar chose to rank and rate ETFs against the larger open-end categories. Open-end funds and ETFs are fairly similar investments, and the open-end population forms a more reasonable peer group for these ratings. First, open-end funds are ranked within their categories and stars are assigned as follows:

• Top 10% five stars

• Next 22.5% four stars

• Middle 35% three stars

• Next 22.5% two stars

• Bottom 10% one stars

After the open-end funds are rated, Morningstar compares the ETF risk-adjusted returns to the open-end breakpoints for risk-adjusted return between each rating level.

Exchange-traded funds are rated for up to three periods, the trailing three, five, and 10-years, and ratings are recalculated each month. For funds that remain in the same Morningstar Category for the entire evaluation period, the following weights are used to calculate an overall rating:

If an ETF changes Morningstar Categories, its long-term historical performance is given less weight, based on the magnitude of the change.