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What? No Analyst Picks? Try an ETF Instead

When good choices are limited in these categories, consider these ETFs.

Dan Culloton, 01/09/2007

Morningstar mutual fund analysts scour more than 2,000 mutual funds to come up with picks in each of our nearly 60 categories. (Analyst Picks are available in Premium Morningstar.com.) Sometimes, though, the pickings are slim. Some categories don't have a lot of options with everything we look for in an Analyst Pick--which can be boiled down to experienced managers consistently and successfully executing unique, long-term focused strategies in funds with reasonable expenses.

When choices are limited, you may consider turning to exchange-traded funds to get the exposure you need. Conventional index mutual funds are decent alternatives in many but not all categories. In recent years, however, ETFs have emerged in areas that have few if any traditional index alternatives. ETFs can offer low costs and tax-efficient, diversified, and transparent exposure to the segment of the market you want.

Not just any ETF in a given category will do, though. The rapid proliferation of ETFs in the last couple of years has made it necessary to be selective. Otherwise, you might plunk your money into an ETF that doesn't provide the exposure, risk profile, cost savings, or tax efficiencies you want. To get you started, here is a list of some categories for which we currently have no Analyst Picks and some ETFs that might serve as decent stand-ins.

Natural Resources
There have been a ton of new ETFs launched in this category in the last year; more than half of the 26 ETFs in this category hit the market in 2006. It's no coincidence that the energy sector, which consumes a big portion of natural-resources portfolios, also has been one of the hottest spots in the market of the last five years.

The exuberance on the part of ETF purveyors alone, not to mention high valuations and unpredictable commodity prices, should serve as a warning to investors seeking more exposure here. So should the fact that many natural-resources ETFs are too narrowly focused to be of much practical use, and they're expensive for index funds. For example, many of the energy-stock ETFs concentrate their assets in holdings, such as ExxonMobil XOM and Chevron CVX, that are already well represented in more-diversified portfolios. Even a very cheap option that owns a lot of individual stocks, Vanguard Energy ETF VDE, keeps 30% of its assets in those two stocks. Newer offerings, such as United States Oil ETF USO or SPDR Oil & Gas Equipment & Services XES, track the price of one very fickle commodity or thinly sliced subsector or industry. That's a recipe for volatility, as United States Oil's nearly 26% plunge in the second half of 2006 demonstrates.

Funds in this area are not without utility, though. They can provide a portfolio with diversification and inflation protection. Commodities, for example, have historically zigged when equity markets have zagged. That's why one of the more interesting ETF options in this group is iPath Dow Jones-AIG Commodity Total Return Index ETN DJP. It isn't an ETF per se. It's an exchange-traded note backed by the corporate parent of iShares' advisor, Barclays Bank PLC. The bank promises to pay investors the return of the Dow-Jones AIG Commodity Index, minus a 0.75% fee. That low fee, relative to other conventional natural resource funds, is one of the ETN's main attractions. Another is diversification; its benchmark includes 18 different commodities and caps energy at 33%. ETN's also don't pay out ordinary income or short-term capital gains, making them more tax friendly than other commodity funds. Be careful, though. This is a notoriously fickle asset class that is coming off a multiyear rally.PAGEBREAK

Japan
Many funds in the Japan stock category have seen a lot of manager turnover, have high expenses, or have poor histories of delivering consistent risk-adjusted returns. Japanese stocks also make regular appearances in more diversified international funds; the majority of large-cap foreign funds keep about one fifth of their assets in stocks from that country. So it would be wise to check how much exposure you have to Japanese stocks before seeking a fund from this group. 

There are a couple of viable options for those who need more, such as Matthews Japan MJFOX and T. Rowe Price Japan PRJPX, but nothing deemed pick-worthy now. If you'd rather not take a chance on those, you could do worse than iShares MCSI Japan Index EWJ, which cost about half as much as those conventional near-picks and provides exposure to 85% of the Japanese market. It leans heavily on bellwethers, such as Toyota TM and Sony SNE, so there is a good chance it will overlap with any diversified foreign funds you own.

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