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ETF Lessons from the Year's First Half

It was all about heavy metal in the first six months of this year.

Dan Culloton, 07/10/2007

We all know that past performance is a poor indicator of future results, but let's face it: It's impossible not to peek now and then to see how your portfolio and its holdings are doing. With the year half over, I took a look at the exchange-traded fund performance tables. Here's what jumped out at me.

REITs Retreat
Is this the long-feared REIT correction? Only hindsight will tell for sure, but it certainly was a rough six months for ETFs in Morningstar's real estate category. Most took a tumble. During the six months ended June 30, 2007, iShares Cohen & Steers Realty Majors ICF fell by 8.6%, Dow Jones Wilshire REIT RWR fell by 6.5%, Vanguard REIT Index VGSIX dropped by 6.3%, and iShares Dow Jones US Real Estate IYR dropped by 6.2%.

This may surprise some who expected that low unemployment, a fitful but still growing economy, and a brisk market for buyouts would continue to support demand for the apartments, offices, and shopping malls that underpin many REITs. It shouldn't come as a surprise, however, to those who have paid attention to these stocks' valuations. They've looked high by a number of measures for a long time. You could blame the REIT retreat on any number of factors--spillover from the troubles in the residential real estate market or some weaker-than-expected economic reports. But rising Treasury interest rates seem a likely cause. REITs often suffer when bond rates rise because income-seeking investors can get relatively safer yields in the fixed-income market. Plus, after rising about 300% from the start of 2000 through June of this year, REITs were ripe for a fall.

So, have they fallen enough to become interesting? Our stock analysts say the sell-off has created selected bargains. Office REITs that own property in suburban markets such as Brandywine Realty look attractive, for example, they say. On average, though, the valuations of the ETFs in this sector are still rich, according to Morningstar's equity analysts. The price/fair value of each of the ETFs mentioned above are still about 1.2 (with any number above 1.0 indicating overvaluation), and with Treasury interest rates up since the start of the year, REITs' low yields look even less attractive on average.

Home Wreckers
ETFs focused on homebuilders plunged during the first half, as the housing sector continued to crater. For the year to date ended June 30, iShares Dow Jones US Home Construction ITB fell nearly 26% and SPDR S&P Homebuilders XHB dropped more than 18%.

There were two kinds of news for this sector in the first half: bad and worse. The meltdown in the subprime-mortgage market and slowdown in home sales have conspired to give homebuilders a massive inventory hangover. I have no idea when the housing sector will hit bottom and start improving. Indeed, there could be more pain in store for investors as the excesses are bled out of the mortgage market and homebuilders bring the supply of homes in balance with demand. Our stock analysts, however, think there are several companies in the sector that are well positioned to weather the storm and whose stock prices are attractive. These include Lennar LEN, Pulte Homes PHM, and Meritage Homes MTH, companies that have significant stations in both iShares Dow Jones US Home Construction and SPDR S&P Homebuilders.PAGEBREAK

These are focused and risky ETFs. We also have been saying that homebuilders look cheap since last year and have been early--to put it mildly. But the homebuilding ETFs have some of the lowest price/fair value measures among domestic-stock ETFs and may pay off over the long run. Even so, they are only suitable for intrepid investors who want to make a contrarian call with a small portion of their diversified portfolios. My colleague Sonya Morris, editor of Morningstar ETFInvestor, owns iShares Dow Jones US Home Construction in the newsletter's Hands-On Portfolio.

ETFs of Steel
So, if REITs and homebuilders have been in the dumps, what about the leaders? In the first half of the 2007, it was all about heavy metal. Market Vectors Steel SLX jumped 42.5%, and iShares MSCI Brazil EWZ, which has significant exposure to metal and mining stocks, rose nearly 30.8%.

As enticing as those returns look and as convincing as the argument for continued high demand for steel is (essentially that China is still ravenous for it), I'm wary of these ETFs. Like all industry-specific ETFs, they are concentrated and volatile (not to mention more expensive than the average ETF). But these ETFs also have huge stakes in some richly valued companies. For example, iShares MSCI Brazil and Market Vectors Steel have big helpings of the world's largest exporter of iron ore, Companhia Vale Do Rio Doce RIO, which was up 63% for the year through June 30 and more than 100% over year-end on that date. Our stock analysts gave 1 star to Companhia Vale Do Rio Doce and several other steel stocks, meaning that they are trading significantly over their fair value estimates. I would need a much larger margin of safety to invest in anything like this. Right now there is little to no margin of safety for these ETFs.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.

Dan Culloton is a senior analyst with Morningstar.

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