Use an ETF to short an overvalued and heavily uncertain industry.
For investors in most airline companies, 2010 has been a terrific year. Most air carriers' stock prices soared in 2010--a marked departure from the previous several years of pain from a weak economy, excess capacity, and oil price increases that in 2008 made fuel expenses their highest percentage of airline operating costs ever.
Driving this outperformance have been both fundamental and non-fundamental factors. The industry has emerged from the recession healthy, with passenger volumes rising nicely on effectively flat ticket prices and the carriers' non-fuel costs down or growing modestly at best. In addition, stock prices have been buffeted by a wave of consolidation that has begun taking place; Southwest Airlines
Explosive Stock-Price Returns
Holders of almost all airline companies have been rewarded nicely in 2010. United Continental, for instance, was up 125% in the first 10 months of 2010, while US Airways
Traditional open-end mutual funds have modest exposure at best to the airline industry. Instead, we believe that the best way to gain exposure to the entire airline industry while avoiding single-stock risk is through an exchange-traded fund. In addition, we highlight that the ETF structure offers some flexibility for investors that traditional mutual funds do not offer, including the ability to short an ETF that an investor believes is overvalued.
Investing in an Airline ETF
Right now, investors can consider just one airline ETF, Guggenheim Airline
Given current industry fundamentals and FAA's high valuation, we believe that this ETF would make a compelling short opportunity for an investor.
First, there is no question that investors in the airline industry need a strong stomach. There have been more than 180 bankruptcies in the industry over the past 30 years, and since deregulation in the late 1970s, the industry has been plagued by issues like capital intensity, minimal customer-switching costs, and cutthroat competition. In more recent years, oil-price volatility has only exacerbated the industry's structural issues. Indeed, famed investor Warren Buffett purchased preferred shares in US Airways (then known as USAir) in the early 1990s and later rode the company into bankruptcy before recovering and booking a small profit; Buffett has lamented that investment, calling it his worst one ever. He also has noted that in the airline industry, "you've got huge fixed costs, you've got strong labor unions and you've got commodity pricing. That is not a great recipe for success." And while, as we noted above, we are encouraged by better and more rational behavior on the part of the airlines in the form of capacity discipline and cost containment, the industry has to overcome a long track record to the contrary. On top of this, recently rising fuel costs have not yet begun to affect airlines' earnings results but undoubtedly will in coming quarters, quite possibly to a level greater than the carriers are suggesting in their guidance.
In addition, the valuation of air carriers is very high, in our opinion, and bound to revert to the mean, given that merger premiums appear to be baked into many companies' share prices. Although further consolidation unquestionably is ahead, we do not believe that all carriers will be acquired away, meaning that share prices are likely to fall back down to earth. Also, of the nine U.S-listed companies in this fund that Morningstar's equity analysts follow (comprising almost 69% of the assets of this ETF), just two--United Continental and AMR--trade at any meaningful discount to our analysts' fair value estimates. The other seven all trade at or above our analysts' fair value estimates. In addition, Morningstar's equity analysts assign uncertainty ratings of "very high" to five of these nine companies, and "extreme" uncertainty ratings to the other four: Delta, American, US Airways, and United. We believe those factors make an ETF that is ripe to be shorted.
FAA charges an annual expense ratio of 0.65%, which may seem high. However, this ETF holds airline stocks traded on exchanges all around the world, and it would be very costly for investors to try to assemble this same portfolio of companies on their own. We also would alert investors that this ETF is not very liquid, meaning that investors should keep a close eye on bid-ask spreads when transacting. That said, individual investors using limit orders for FAA probably won't run into any liquidity issues. And, we'd also note that taking an outright short position in a security, including an ETF, can expose investors to the unlimited loss potential if the ETF continues to rise. In addition, the expense ratio actually serves as a slight tailwind for the investor who is short.
Few Other ETF Options
Right now, FAA is the lone ETF with any meaningful exposure whatsoever to the airline industry. Other ETFs in which airline companies are included make fairly ineffective options for an investor who is searching for airline exposure. For example, five airline companies are included in the shipper-intense iShares Dow Jones Transportation Average
Note that ETF providers are known for chasing returns, with good-performing sectors typically having several product launches while they're hot. However, until recently, aviation has not had a prolonged period of strong returns while ETFs have been growing. So we would not be at all surprised to see other ETF providers launch niche aviation-themed ETFs in the future.
Robert Goldsborough is an ETF analyst with Morningstar.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.