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Fund Spy

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

Funds our stock analysts would and wouldn't buy in the current market.

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Beware of exchange-traded funds that focus on energy and basic materials. They look overvalued. On the other hand, financial and consumer-goods ETFs look cheap. That's the verdict of a new method of melding Morningstar's stock and fund research.

If you haven't noticed by now, in addition to a staff of 25 mutual fund analysts, Morningstar has nearly 75 in-house equity analysts researching and estimating fair values for more than 1,500 stocks. Given Morningstar's historic focus on mutual funds, it seems natural to find ways to tap that stock research to help measure the attractiveness of mutual fund portfolios. Recently, Vahid Fathi, our director of stock research, developed such a method for evaluating ETFs. We're tentatively calling it the Morningstar price/fair value ratio for ETFs. It basically tries to offer a bottom-up assessment of whether an ETF portfolio is cheap or expensive by gauging if its holdings, on average, are trading above or below their Morningstar fair value estimates.

The process is pretty straightforward. We calculate the market value of all the holdings in the ETF for which we have fair value estimates. Then we use the fair value estimates of those stocks to calculate what we believe is the fair value of the same portfolio. Lastly, we compare the two numbers and calculate the percentage premium or discount of the market value compared to the fair value. If the percentage difference is positive, the portfolio is overvalued. If it's negative, the fund is undervalued.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.