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Fund Spy

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

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

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It's been about seven months since we first used Morningstar's ETF price/fair value measure to take the temperature of the market and various sectors. As 2005 draws to a close, the song remains the same: Energy and basic-materials ETFs still look expensive, while consumer-goods and financial ETFs look undervalued.

Before we tackle the specifics, let's review the mechanics of the price/fair value ratio. This statistic is Morningstar's way of tapping the research of its 85 in-house equity analysts who research and estimate fair values on more than 1,600 stocks to help evaluate the attractiveness of ETF fund portfolios. The measure basically tries to offer a bottom-up assessment of whether an ETF portfolio is cheap or expensive by gauging whether its holdings, on average, are trading above or below their Morningstar fair value estimates.

To get the price/fair value ratio, 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. Finally, we compare the two numbers and calculate the percentage premium or discount of the market value relative to the fair value estimate. When that difference is expressed as a ratio, a number more than one means the ETF's portfolio is overvalued; less than one indicates it 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.