The ALTAR™ score

The AltaVista Long Term Annual Return forecast, or ALTAR™ score, is our proprietary measure of an ETF's overall investment merit. Akin to a rating, it is prominently featured in all the data and research we publish. Below are answers to common questions to help explain how it works and how you can use it to quickly compare ETFs.

What is the formula for calculating the ALTAR™ score?

The formula is as follows:

Avg. ROE ÷ P/BV - expense

where Avg. ROE is the average return on equity of the companies in the fund for the 5 years leading up to and including the current-year forecast; P/BV is the price-to-book value based on current market prices; and expense is the annual expense ratio of the ETF.

How does the ALTAR™ score work?

There is nothing inherently good or bad about a particular basket of stocks that an ETF holds—be it a sector, regional, or style fund. Rather, the investment merit of an ETF is determined by two factors: market conditions (valuations), and the underlying fundamentals of the stocks which comprise the fund.

The ALTAR™ score is designed to help you think like a business owner. In other words, if you had enough money, would you want to buy the entire business? Average ROE provides a decent estimate of a firm's inherent profitability over the business cycle (which, or course, is what the stock market is ultimately trying to discount). Using average ROE also allows us to compare funds where the constituents firms are at different stages of the economic cycle.

But a firm's profitability is only part of the investing equation; valuations are equally important. Suppose a firm with $100 in book value, or owner's equity ("equity" and "book value" are interchangeable here) has a 10% ROE: it would be expected to have profits of $10. However, if shares are currently trading at 2.0x book value (i.e., a market cap of $200) then the expected return on your money if you invest is only 5%, because the firm is still only expected to bring in $10 profits regardless of what you paid. Thus, dividing average ROE by P/BV gives a reasonable estimate of the return you can expect over the long run.

Finally, fund expenses are subtracted from expected returns since they eat into your profits. Typically ETF expenses are far lower than those for similar mutual funds. Still, they can be significant, especially for some more cumbersome categories such as foreign stocks.

How should ALTAR™ score be used?

Use the ALTAR™ score to compare ETFs on investment merit, both within a given category or across categories. Consider buying ETFs with a relatively high ALTAR™ score, as this indicates the market may be undervaluing the true earning potential of constituent companies. Consider selling (or shorting) ETFs with a relatively low ALTAR™ score since this indicates the opposite may be true.

How should the ALTAR™ score NOT be used?

Nothing in the ALTAR™ score deals with momentum, either of price or earnings. As a result, the ALTAR™ score likely has little if any predictive power concerning near-term price movements. Over time the market follows fundamentals, but conditions that later prove to be anomalies can persist for years at a time (remember the late 90's?).

Also, as with any fund ratings, investors should not simply select a portfolio consisting of a few ETFs with the highest ALTAR™ scores, as these may be highly correlated to each other. It is more important to build a well diversified portfolio, using the ALTAR™ score to inform your judgments on both A) which areas to focus on and which to avoid; and B) which funds within each area look best.

Ultimately, investing based on fundamentals, whether in single stocks or in ETFs, comes down to a judgment call. Use the ALTAR™ score as one more tool to help you make better, more informed investment decisions that conform to your own objectives.

How has the ALTAR™ score performed in the past as an indicator of value?

Because most ETFs have very limited history, it is impossible to measure directly how the ALTAR™ score would have fared over a substantial time frame (since it is impossible to say what an ALTAR™ score would have been on a fund that did not exist).

However, the concept applies to single stocks as well. So in order to test the validity of the ALTAR™ score in the real world, we created a simple portfolio consisting of the 100 stocks in the S&P 500 with the highest ALTAR™ scores on January 1 of each year, and simply held the market cap-weighted portfolio for one year, and then rebalanced. The results, illustrated in the graph at left, shows that the ALTAR™ portfolio fared considerably better than the market, gaining 9.1% per annum compared with 0.1% for the S&P 500 between Jan. 2000 and July 2007.

How is the ALTAR™ score different from Morningstar's star rating system?

The ALTAR™ score, like all our ETF research, is designed to be forward looking. In contrast, Morningstar's ratings focus exclusively on past performance and fees. In fact, according to materials on their website, "The Morningstar™ rating for exchange traded funds uses the same methodology as the Morningstar™ Rating for [mutual] funds."

As a result, since Morningstar's methodology requires at least three years of trading history, ratings cannot be calculated for many of the newer ETFs on the market. Further, while a fund that has performed poorly in the past would likely receive a low rating because of relatively poor performance, the ALTAR™ score may go up as a result, simply because valuations of the funds holdings are more attractive. (It is also possible the ALTAR™ score would fall if fundamentals had deteriorated considerably).

Lastly, the ALTAR™ score is a number that depends only on the holdings of the fund itself; the Morningstar Rating gauges performance relative to other funds which Morningstar classifies as belonging in the same category. Therefore you cannot compare fund ratings across categories. In contrast, using the ALTAR™ score you can not only gauge the attractiveness of, say, different small cap ETFs; you can also compare the attractiveness of a small cap ETF and a large cap ETF. 

Why is the ALTAR™ score constantly changing?

Because the factors which upon which it is calculated, fundamentals and market conditions (valuations), are always changing. Although the relative rankings between funds don't typically change drastically from day to day, in volatile markets or over several weeks the picture can change. We update our calculations in the Online Tools section of the site so that subscribers can keep on top of changing markets.