How we rate ETFs. Ultimately the goal of conducting investment research is to help investors make money. To that end, we calculate an ALTAR Score™—short for AltaVista Long Term Annual Return forecast—for each ETF we cover, which summarizes the results of our fundamentally-driven analysis.

ALTAR Score™

The ALTAR Score™—short for AltaVista Long Term Annual Return forecast—is our measure of an ETF's overall investment merit. It was designed to evaluate passive index funds like ETFs based on their underlying holdings, in contrast to most performance-based rating systems which were designed decades ago to evaluate the managers of active mutual funds. Expressed as a percentage, the ALTAR Score™ helps facilitate comparisons between funds, both within an across fund categories.

Calculation of ALTAR Score™

For equities, we calculate the ALTAR Score™ using the formula on the right—itself a derivation of the old Dividend Discount Model—where:

• Avg. ROE  is the average return on equity of firms in the fund for the five (5) years up to and including the current forecast year
• P/BV  is the forward price-to-book value based on current market prices
• fees  is the annual expense ratio of the ETF

The relationship between Return on Equity and Price-to-Book Value multiples is well established in the academic literature. This formula is designed to forecast the likely internal rate of return to business owners. It is important to note that it is not a target price, and there are no timing or momentum components to it.

---

For fixed income securities, investors' returns over the long term are determined by a bond's yield to maturity (YTM), less principal lost when borrowers are unable to repay. For Fixed Income ETFs, we calculate this as follows:

• Adjusted YTM.  Adds implied inflation back to real YTM for inflation-linked bonds so that all instruments are compared on a nominal basis
• less: Annual "default factor."  Our estimate of the impact of potential defaults on investor returns, based on historical default and recovery rates for bonds of similar credit rating and maturities
• less: Expense ratio.  Annual expense ratio of the ETF

Recommendations

For equity ETFs we also distill ALTAR Scores™ into a traditional five-tier recommendation system based on how each fund's score ranks in relation to the other ETFs in its category. Our recommendation tiers are as follows:

SPECULATIVE

A rating of SPECULATIVE is assigned to ETFs with ALTAR Scores in the top quintile (the top 20%) of their category, indicating exceptional appreciation potential. However, often these are narrowly-focused funds or in industries with structural issues, which may also make them very risky. Nonetheless they may still be useful as part of a well-diversified portfolio.

OVERWEIGHT

A rating of OVERWEIGHT is assigned to ETFs with ALTAR Scores in the 4th quintile (ranking higher than 60%-80%) of their category. Typically, funds in this category consist of stocks trading at attractive valuations and/or having above-average fundamentals.

NEUTRAL

A rating of NEUTRAL is assigned to ETFs with ALTAR Scores in the middle quintile (ranking between 40%-60%) of their category. This indicates that valuations adequately reflect the fundamentals of stocks in these funds.

UNDERWEIGHT

A rating of UNDERWEIGHT is assigned to ETFs with ALTAR Scores in the 2nd quintile (ranking higher than only 20%-40%) of their category. Typically, funds in this category consist of stocks trading at relatively expensive valuations and/or having below-average fundamentals.

AVOID

A rating of AVOID is assigned to ETFs with ALTAR Scores in the lowest quintile (the bottom 20%) of their category. Often, funds in this category consist of stocks with little if any history or expectation of profitability, and as a result our fundamentally-driven analysis may be less relevant.