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ETFs for Your Watch List--and Some to Avoid

Here is an update on ETF valuations.

Sonya Morris, 05/08/2007

Here at Morningstar, one way we evaluate an exchange-traded fund's attractiveness is by examining the valuation characteristics of the underlying holdings. A handy tool for that task is the price/fair value ratio, which is based on the stock fair value estimates that are produced by Morningstar equity analysts. To compute the ratio, we calculate the aggregate market price for the ETF's underlying holdings and divide that number by the asset-weighted fair value estimate of those stocks. A price/fair value ratio above 1.0 indicates that an ETF is overvalued because its market price exceeds the collective fair value estimate of its holdings. By the same token, a price/fair value ratio below 1.0 suggests that the ETF is cheap.

The price/fair value ratio is made available each month to subscribers of Morningstar ETFInvestor. (To learn more about our newest monthly publication, click here.) But because there are also lessons here for fund and stock investors, we occasionally update our analysis for Web readers as well. We concentrate our analysis on those ETFs with at least two thirds of assets under coverage by Morningstar equity analysts.

Many of the same themes persist since the last time we visited this topic last summer. If anything, the market appears more fairly valued almost across the board. Nevertheless, there are a few undervalued and overheated areas that are worth noting.

The Cheap
Those ETFs that focus on the market's biggest names--such as Rydex Russell Top 50 XLG and SPDR DJ Global Titans DGT--look cheap relative to those that emphasize small- and mid-cap stocks. After trailing their smaller cousins for years, mega-caps have taken on attractive valuation characteristics in recent months. To illustrate the relative attractiveness of big blue chips, let's compare Rydex S&P Equal Weight RSP with iShares S&P 500 IVV, which have price/fair value ratios of 1.02 and 0.98, respectively. The Rydex ETF looks slightly overvalued because it assigns equal weighting to all the stocks in the S&P 500, and as a result, it gives much less emphasis to the relatively inexpensive market giants that dominate the market-cap-weighted iShares S&P 500. Going a step further, the iShares S&P 100 OEF, which concentrates on the 100 largest firms in the United States, has an even lower price/fair value ratio--0.95--than the iShares S&P 500. The data do not indicate that mega-caps are screaming bargains, but they're still cheap relative to their smaller cousins. So, if your portfolio's allocation to smaller stocks has grown beyond your targeted weighting, now's a good time to rebalance in favor of sturdy blue-chip stocks.

As measured by ETF price/fair value ratio, the homebuilding sector is the cheapest corner of the market. Homebuilding stocks have gotten punished by investors' reaction to a weakening housing market, pushing down the price/fair value ratios of iShares Dow Jones US Home Construction ITB and SPDR S&P Homebuilders XHB. Although these stocks have experienced a fair amount of turbulence in recent months, they've begun to show signs of strength lately. For instance, iShares Dow Jones US Home Construction gained 7% for the month of April. Granted, homebuilder ETFs are not for risk-averse sorts, but it's an intriguing area for bolder bargain-hunters with the patience and risk tolerance for a more aggressive play.

 Undervalued ETFs
Fair Value
iShares S&P 100 OEF
Rydex Russell Top 50 XLG
SPDR DJ Global Titans DGT
iShares Dow Jones U.S. Home Construction ITB
SPDR S&P Homebuilders XHB
Data as of April 27, 2007

The Dear
The REIT sector continues to look overheated. REIT ETFs, including iShares Cohen & Steers Realty Majors ICF and Vanguard REIT Index ETF VNQ, all sport lofty price/fair value ratios. REITs have defied expectations and continued to rally in spite of nose-bleed valuation levels and historically low yields. Sure, it can make sense to have some real estate exposure in your portfolio, but given today's valuation levels, now's not the time to jump in. Furthermore, if you already own REIT funds, we'd recommend trimming your exposure back to your intended allocation levels.

The oil-service sector also looks pricey. The few ETFs that invest exclusively in oil-service and -equipment stocks, such as iShares Dow Jones US Oil Equipment Index IEZ and SPDR S&P Oil & Gas Equipment & Services XES, claim some of the highest price/fair value ratios in the ETF arena. This is perhaps the most volatile segment of the energy sector; the industry is highly competitive, and demand for energy services is highly dependent on fickle commodity prices. Moreover, these firms have a poor record of generating economic profits over the long haul. Today's valuation levels suggest that now is a particularly dangerous time to make a play on this ticklish area of the energy sector.

Market Vectors Gold Miners GDX is the only gold ETF that invests in gold producers rather than the yellow metal itself. Currently, this ETF sports a hefty price/fair value ratio of 1.66. With gold prices trending near historic highs, investors have flocked to gold-producers stocks, bidding up their prices. But this is also a volatile corner of the market, and now's not the most auspicious time to jump onto the gold bandwagon.

 Overvalued ETFs
Fair Value
iShares Cohen & Steers Realty Majors ICF
iShares Dow Jones U.S. Oil Equipment Index IEZ
SPDR Oil & Gas Equipment & Services XES
Market Vectors Gold Miners GDX
Data as of April 27, 2007

Sonya Morris is an analyst with Morningstar.

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