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

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.

Because Morningstar does not estimate a fair value for every stock an ETF might own, the relevance of the results of the price/fair value depends on how many stocks in a given portfolio have received a fair value estimate and the percentage of that portfolio's assets these stocks represent. As it turns out, our stock coverage is pretty comprehensive for the vast majority of the domestic large-cap ETFs: Morningstar analysts have assigned fair value estimates to stocks representing 75% or more of the asset values of all but a handful of the 68 ETFs in that space.

What is the price/fair value ratio telling us right now? The overall market at the end of April looked slightly undervalued. Total-market ETFs, such as the Vanguard Total Stock Market Vipers (VTI), iShares Dow Jones US Total Market (IYY), and  iShares Russell 3000 (IWV) were all trading about 3% under the weighted average of their holdings' fair values. The  SPDR (SPY), which tracks the S&P 500, was undervalued by about 4.3%, according to the ratio

Broad-Market ETFs
ETF	% of Assets w/ FV Estimates	Price/Fair Value (%)
iShares Russell 3000 Index (IWV)	88.1	-3.1
iShares DJ US Total Market (IYY)	90.8	-3.0
Vanguard TSM VIPERs (VTI)	84.6	-2.9

That reading isn't far from the assessments of market-watchers (including some here at Morningstar) who argue that the S&P 500 and the broad stock market are, at best, fairly valued. Equities have gotten cheaper in recent months as the market has retreated. Most of these ETFs' top-25 holdings (where one fourth or more of their assets are concentrated) are trading below their Morningstar fair value estimates; some of them, such as  Microsoft (MSFT),  Coca-Cola (KO), and  United Parcel Service (UPS), by decent margins. Modestly undervalued core stock indexes also jibe with what some astute money managers, such as  Oakmark Select's (OAKLX) Bill Nygren, have been saying for some time: There are some large, high-quality companies out there with shares available at decent prices.             

The differences are starker among the sector ETFs. Energy-focused ETFs, such as iShares Goldman Sachs Natural Resources (IGE) and  Energy Select Sector SPDR (XLE) looked more than 13% overvalued at the end of April. That's not shocking, especially since high oil prices have drawn investor capital to these stocks the way Brad Pitt attracts paparazzi. So the real surprise here may be the size of the Energy ETF's premium. Why isn't it larger? After all some energy services stocks, such as oil and natural gas driller  Rowen Companies , are trading at twice their fair values. The answer is concentration. The indexes these funds track lean heavily on major energy companies whose stock prices are closer to their fair values. That checks the portfolios' overall premium somewhat. For example, oil giant  ExxonMobil (XOM), which eats up 20% of the Energy Select Sector SPDR and nearly 8% of the iShares Goldman Sachs Natural Resources ETF, is trading less than 4% above its fair value estimate.

Overvalued ETFs
ETF	% of Assets w/ FV Estimates	Price/Fair Value (%)
iShares DJ Basic Materials (IYM)	88.9	8.4
iShares DJ US Energy (IYE)	96.2	11.1
iShares GS Network (IGN)	89.3	11.7
Energy SPDR (XLE)	94.3	13.3
iShares GS Natural Resources (IGE)	91.0	13.3

Meanwhile, concerns about rising interest rates and a scandal in the insurance industry have left financial-focused ETFs Vanguard Financial Vipers (VFH) and  Financial Select Sector SPDRs (XLF) 9.3% and 10.7% undervalued, respectively. Some of the stocks in these portfolios carry significant short-term risks. For example,  American International Group (AIG), which has fallen 30% below its fair value estimate amid accounting contretemps and boardroom upheaval, likely will restate its financial statements. While that is sure to hurt, it shouldn't impinge the long-term prospects of this insurer, which takes up more than 6% of the Financial SPDR. The company, known for its strict underwriting, global reach, and entrepreneurial instincts, has been one of the most consistently profitable firms in its industry and should have the financial strength to ride out the storm.

Undervalued ETFs
ETF	% of Assets w/ FV Estimates	Price/Fair Value (%)
iShares DJ US Financial Sector (IYF)	90.2	-8.9
iShares DJ US Financial Services (IYG)	89.5	-9.2
Vanguard Financial VIPERs (VFH)	84.1	-9.3
Consumer Staple SPDR (XLP)	97.6	-10.3
Financial Select Sector SPDR (XLF)	93.3	-10.7

The price/fair value ratio had interesting things to say about other sectors, too.

• ETFs focused on steel, aluminum, paper, and chemical companies, such as iShares Dow Jones US Basic Materials (IYM) and Vanguard Materials Vipers (VAW), also looked overvalued by 7.2% and 8.4%, respectively. Big holdings, such as chemical maker  DuPont De Nemours  and aluminum maker  Alcoa  are trading near their fair values, while others, such as gold miner  Newmont Mining (NEM) and  Monsanto , look pricey.
• Consumer-goods ETFs (which own brand-name stocks like  Procter & Gamble (PG) and Coca-Cola) such as Vanguard Consumer Staples Viper (VDC) and the Consumer Staple SPDR (XLP) were among the most undervalued. Perhaps Warren Buffett, whose  Berkshire Hathaway (BRK.B) recently invested in brewer  Anheuser-Busch (BUD), is on to something.
• Some, but not all, technology ETFs looked to be trading at a discount. The large-cap-focused  Technology SPDR (XLK), whose top holding is the currently 5-star-rated Microsoft, was 4.5% undervalued according to the measure. However the iShares Goldman Sachs Networking (IGN), which follows a motley collection of telecom-equipment makers ranging from the fiber-optics firm  Corning (GLW) to telecom equipment maker  Lucent Technologies , was nearly 12% overvalued. The disparity dramatizes a lot of what has gone on in the tech sector in recent years. Networking stocks, including Corning and Lucent, were among the biggest losers in the bear market, but got the biggest bounce when the market recovered in 2003 and 2004. (Corning has continued climbing this year.) Now their prices have gotten ahead of their business fundamentals. The shares of giant tech companies that make up the Technology SPDR, such as Microsoft and  Dell , have lagged, and now their prices underestimate their prospects.   

This data suggests that now is probably a dangerous time to chase the recent hot returns of the energy and materials sectors. It's usually a bad idea to chase hot money, and natural-resources funds have been sizzling. The category was one of the most popular in 2004 and gathered $5.6 billion in the first quarter of 2005, making it one of the 10 best-selling fund groups. That could be a sign that it's time to harvest some winnings and funnel the proceeds or new money to financials or consumer staples. You could use an ETF or a traditional sector fund. You could even use a diversified-stock fund that has a lot of exposure to the sector. Just be sure to do it within the context of a diversified, long-term portfolio.

I Scream, You Scream, We All Scream for an ETF Screen
The price/fair value ratio isn't the only new tool for ETF investors at Morningstar. This week we unveiled a new ETF Screener. It allows investors to sift through the 164 ETFs currently available by asset class, category, expense ratio, fund family, performance, or any combination of those criteria. Let's say that after reading this article you're interested in finding financial sector ETFs with expense ratios under 0.30%. Just go to the ETF Screener, select "Specialty-Financial" from the Morningstar Category drop-down menu, and select "Less than or equal to 0.30%" from the Expense Ratio menu. Once you click the button to view results, you'll see that your choices have been narrowed to two ETFs: the financial Vipers and SPDRs. Happy hunting.

Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares that are based on Morningstar indexes.