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ETFs: The Cheap, the Dear, and the Fairly Valued

An update on funds our stock analysts would and wouldn't buy today.

Dan Culloton, 04/11/2006

Looking for bargains in a fairly valued market? Look beyond Asian and real-estate stocks and toward mega-cap equities. And though energy stocks don't seem as overvalued as they were at the end of 2005, they still aren't a great deal.

So says Morningstar's price/fair value ratio for exchange-traded funds. At the start of 2006's second quarter, we revisited the measure that uses the fair value estimates set by Morningstar's 90 equity analysts for 1,700 stocks to determine if ETFs' underlying holdings are, on average, trading above or below their worth. To make sure we were getting an accurate reading, we focused on ETFs that had Morningstar fair value estimatess for more than 80% of their holdings. Here's what we found.

Broadly Speaking

The broad market, as defined by the all-encompassing stock indexes tracked by Vanguard Total Stock Market VIPERs VTI, StreetTRACKS Total Market ETF TMW, and other offerings, looked fairly valued at current levels.

The valuations of the energy ETFs, on the other hand, don't look quite as lofty has they did a few months ago. This reflects recent price retreats of a few of the sector's biggest winners of recent years, such as Southwestern Energy SWN, as well as the reality that burgeoning Asian demand, steady consumption in the United States, and the need to spend more money on oil and gas exploration and production underpin the rally. A lot of that optimism is already baked into energy-stock valuations, though. Many of the largest holdings in energy-heavy ETFs such as iShares Goldman Sachs Natural Resources IGE are trading above their fair value estimates, including oil-services giants Schlumberger SLG and Halliburton HAL. That suggests that the future of these ETFs might not be as bright as their recent past.

 Broad Market ETFs
% of Assets w/ Fair Value Estimates
Fair Value
iShares R3000 Index IWV
iShares Dow Jones Total Market IYY
streetTRACKS Total Market TMW
Data as of 04-06-06

Airy Asia

Energy ETFs were not the most overvalued at the start of the second quarter. As of April 6, BLDRS Asia 50 ADR Index ADRA, which tracks an index of Asian stocks that list their shares on American stock exchanges, had the highest price/fair value ratio among the ETFs we examined.

Although it notched lackluster gains in this year's first quarter, the Japanese stock market has rallied strongly in the past three years, and this ETF keeps more than 60% of its assets in the shares of Japanese companies. Furthermore, the fund concentrates more than 15% of assets in just two mega-cap Japanese stocks that are currently trading above their Morningstar fair value estimates: Toyota Motor TM and Mitsubishi UFJ Financial Group MTU. Large helpings of a few richly valued industrial stocks, such as miner BHP Billiton BHP, also make this ETF look frothy.

 Overvalued ETFs
% of Assets w/ Fair Value Estimates
Price/ Fair Value
BLDRS Asia 50 ADR Index ADRA
iShares Cohen & Steers Realty ICF
Vanguard REIT Index VIPERs VNQ
streetTRACKS KBW Capital Mkts KCE
iShares GS Natural Resources IGE
Data as of 04-06-06

Hot Properties

Real estate, the Energizer Bunny of asset classes over the past five years, still looks pricey as well.

No ETF in this area looks richer than iShares Cohen & Steers Realty Majors ICF, which apes an index of the some of the largest REITs on the market. The ETF has gained more than 31% annualized over the past three years and more than 22% annualized over the past five years. In early April, 20 of the ETF's top 25 holdings were trading above their fair value estimates. Vanguard REIT Index VIPERs VNQ, which is less concentrated than the Cohen & Steers ETF, also looked overvalued. More than 80% of its top 25 holdings were trading above their fair value estimates.

Real estate still has value as a portfolio diversifier, but the upside from here could be limited.PAGEBREAK

A Tale of Two Financials

Broader financial sector ETFs, such as iShares Dow Jones U.S. Financial Sector IYF and Vanguard Financials VIPERs VFH, look more or less fairly valued based on our stock analysts' estimates. There are stocks in some financial subsectors at both ends of the valuation spectrum, though.

StreetTRACKS KBW Capital Markets KCE, which tracks a Keefe, Bruyette & Woods index of broker/dealer, asset manager, trust and custody bank, and stock exchange stocks, was among the most overvalued ETFs on April 6. The index is a concentrated dose of companies, such as Goldman Sachs GS and Chicago Mercantile Exchange Holdings CME. Such companies not only have legendary brand names, redoubtable business models, fat margins, and high growth rates, but also the high valuations that often accompany such traits.

Meanwhile streetTRACKS KBW Bank ETF KBE, which tracks Keefe, Bruyette & Woods' index of national and regional banks, was among the most undervalued ETFs. A flat yield curve has hurt the valuations of many of this fund's holdings. This ETF also is very top-heavy, so a couple of company-specific issues can affect its price/fair value ratio. For example, nearly two years after the merger was announced, the market is still taking a wait-and-see approach to J.P. Morgan Chase's JPM combination with Bank One. Similarly, a recently completed acquisition of credit card issuer MBNA as well as some ho-hum quarterly results have restrained Bank of America's BAC valuation. Since J.P. Morgan and Bank of America account for a fifth of this ETFs assets, when they look cheap there's a good chance the fund will, too.

 Undervalued ETFs
% of Assets w/ Fair Value Estimates
Fair Value
Rydex Russell Top 50 XLG
Consumer Staples Select SPDR XLP
streetTRACKS DJ Global Titans DGT
Vanguard Consumer Staple VIPERs VDC
Data as of 04-06-06

Big Opportunities

Size and style also have worked against J.P. Morgan and Bank of America. Profitable mega-cap stocks have lagged the rest of the market over the last three years even as they, in general, have churned out steady earnings. That has resulted in historically low valuation multiples for blue-chip stocks. Thus, ETFs that focus on the biggest of the big, such as the Rydex Russell Top 50 XLG and StreetTRACKS Dow Jones Global Titans DGT, were among the most undervalued ETFs based on our stock analysts' estimates. With few exceptions, such as Hewlett-Packard HPQ and Toyota in the Global Titans fund, these ETFs' holdings are trading at or below our analysts' estimates of their fair value. A bias toward steady, giant-cap stocks, such as Wal-Mart WMT and Coca-Cola KO, also make consumer-goods ETFs look undervalued.

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. He doesn't own shares in any of the securities mentioned above.

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