There are plenty of ways to determine whether an equity-sector ETF is ripe for the picking. When Morningstar's ETF research team looks at sector funds, we consider all the possible variables including secular trends, macro-economic themes, and even sector momentum.
Though all of those factors are important, we think that the most important way to decide whether to invest in a sector ETF is based on fundamental valuation. ETFs are really just the sum of their underlying holdings. Investors could aggregate their implied fair value estimates for all of the stocks in a sector ETF to come up with a fair value for the entire fund. Of course, that would mean doing the valuation homework on literally hundreds of stocks, which generally isn't very practical for most investors.
Luckily, Morningstar has an equity research team covering more than 2,000 stocks with the unique ability to do just that. The ETF team can aggregate and weight our equity fair value estimates for just about any U.S.-themed sector ETF out there. From this aggregation we can provide a fundamental perspective on whether a sector is priced cheaply or dearly.
Morningstar Premium Members can go to our ETF Quickrank page and see for themselves how the ETFs stack up in terms of fundamental valuation. We ran a screen ourselves, and here are the five cheapest funds we found across the sector categories. (We limited our results to one fund per sector to avoid redundancy.) Remember, in these volatile times, deep discounts often go hand in hand with increased risk. We've included our take and highlighted the risks below for each of these funds.
Health Care Select Sector SPDR (XLV)
Price/Fair Value: 0.65
This exchange-traded fund offers investors exposure to a portfolio of high-quality North American health-care companies. Given the sector's lack of sensitivity to the overall economic climate, investors seeking a defensive tilt for a broad-based equity portfolio may consider this ETF a suitable satellite holding. Keep in mind that this fund's holdings comprise 100% of the health-care exposure included in the S&P 500; so in owning this ETF alongside a broad-market fund like SPDRs (SPY), investors are effectively doubling up on their health-care exposure. We'd note that big pharma firms soak up the overwhelming majority of the fund's assets (about two thirds). The fund's heavy exposure in big pharma shouldn't--by itself--deter investors, as the subsector weightings are representative of the health-care industry as a whole. In addition, the fund distributes aggregate dividend payments on a quarterly basis, equating to an annual yield of approximately 2%.
Analyst: John Gabriel
SPDR KBW Bank (KBE)
Price/Fair Value: 0.66
This fund offers investors exposure to a relatively concentrated portfolio of 24 national money center banks and regional banking institutions listed on U.S. stock markets. This ETF fits the bill (as a small satellite holding) for investors seeking exposure to national money center banks while minimizing their exposure to financial subsectors like insurance, money management, and REITs. In any case, this fund's holdings are squarely in the crosshairs of the collapsing domestic financial system via bad loan exposure and deflating asset prices. At this point, we think that overweighting one's financial exposure through a position in this fund represents a high-risk/reward investment scenario.
Analyst: John Gabriel
Market Vectors Gold Miners (GDX)
Price/Fair Value: 0.70
This fund differs from other gold ETFs in an important respect: Rather than own bullion directly, as funds like SPDR Gold Shares (GLD) and iShares Comex Gold (IAU) do, it invests in the shares of firms that mine the precious metal. Of course, the fortunes of gold miners are inextricably linked to the trajectory of gold prices. In that sense, the fund offers a not-so-indirect play on gold. Buying this fund gives you exposure that exhibits significantly greater leverage to gold prices than buying the commodity directly. Keep in mind, however, that leverage can cut both ways. If gold prices fail to rise, or if the cost of mining outpaces the rise of bullion prices, these companies will suffer.
Analyst: Paul Justice
iShares Dow Jones US Home Construction (ITB)
Price/Fair Value: 0.72
The fund holds just 21 stocks, and each of them is narrowly focused on one thing: building homes for Americans. That's been an absolutely horrible business of late, given the collapse of the housing and mortgage market in the U.S. In terms of risk, the homebuilders segment is a mixed-bag of good, bad, and ugly. We've seem some shake-out already with the weaker players folding or being forced to the equity markets to raise additional capital. These riskier names now constitute a much smaller part of the overall holdings, while the stronger firms have begun to show signs of stabilization.
Analyst: Haywood Kelly
Consumer Staples Select Sector SPDR (XLP)
Price/Fair Value: 0.73
Investors seeking shelter from the crisis of confidence in capital markets may consider this a suitable satellite holding. This ETF, which offers exposure to mega-cap household names that consumers continue to transact business with regardless of the economic climate, could be viewed as a defensive tilt for a broad-based equity portfolio. Investors looking for explosive growth are better suited looking elsewhere, however, as this portfolio is chock-full of mature businesses offering relatively stable returns and an average market cap of about $60 billion. As to be expected, consumer goods companies--like Procter & Gamble (PG), Philip Morris International (PM), and Coca-Cola (KO)--dominate the portfolio. There are also a slew of non-discretionary retailers included here, such as Wal-Mart (WMT) and Kroger (KR). While investors shouldn't expect much higher than midsingle-digit top-line growth from these mature firms, the fund does offer a decent dividend yield.
Analyst: John Gabriel
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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.
Scott Burns does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.