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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

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.

It's too young for a hearty recommendation, but there's a new arrival worth mentioning and keeping your eye on in this category. WisdomTree Japan Total Dividend DXJ offers similar access to large- and mid-cap Japanese stocks as iShares MSCI Japan, but it does so a little differently. The WisdomTree ETF weights its constituents by dividend payments instead of market capitalization. It's also slightly cheaper than iShares MSCI Japan, with a projected expense ratio of 0.48%, and spreads its assets a little more evenly across sectors and market cap ranges. Who knows how the dividend-weighted approach will perform in the long run on an absolute and risk-adjusted basis, but it's low costs and diversification make it worth watching.

Diversified Pacific/Asia
Conventional or exchange-traded, regional funds can be rather dicey. Many diversified Pacific/Asia funds, for example, have significant helpings of emerging markets or load up on one particular country, which can make them more volatile than diversified foreign funds. WisdomTree Pacific ex-Japan Total Dividend DND might offer tamer exposure to this part of the globe. It limits its holdings to companies from developed countries in the Pacific Basin, such as Australia, Hong Kong, Singapore, and New Zealand. Like other WisdomTree ETFs, it also ranks the constituents of its portfolio by the size of their dividend payouts, instead of market capitalization. Focusing on income-paying stocks from developed markets could limit the ETF's volatility relative to its peers. Its 0.48% expense ratio also gives it a huge head start on its more expensive rivals.

Small Cap Value and Blend
We actually have quite a few picks in these categories, but I'll suggest some ETF alternatives because most of the picks are closed to new investors. In fact, during this long small-cap rally, pick-eligible conventional funds never seem to stay open long before attracting enough inflows to force their doors shut or, worse, a change in their strategies.

ETFs are attractive options in the small-cap arena because they are index funds that in most cases do not have to worry about asset bloat. There are small-cap value and blend ETFs from StreetTracks and iShares following benchmarks that do a good job of capturing the returns of their asset classes, such as StreetTracks Dow Jones Wilshire Small Cap DSC and iShares S&P SmallCap 600 Value Index IJS. Vanguard, however, offers ETFs in both categories that should offer exposure that is at least as comprehensive as its rivals for about half the expense ratio. When all else is equal, go for the lower-cost options like Vanguard Small Cap Value ETF VBR and Vanguard Small Cap ETF VB.

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.

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