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

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 (ETFs). 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. (Click here for previous versions of this feature and for more detail on how the ratio works). 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
Fund	% of Assets w/ Fair Value Estimates	Price/Fair Value
iShares R3000 Index (IWV)	89.9	0.98
iShares Dow Jones Total Market  (IYY)	92.9	0.98
Vanguard TSM VIPERs (VTI)	88.7	0.98
streetTRACKS Total Market (TMW)	90.2	0.98
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, 2006, BLDRS Asia 50 ADR Index , 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
Fund	% of Assets w/ Fair Value Estimates	Price/ Fair Value
BLDRS Asia 50 ADR Index	84.8	1.43
iShares Cohen & Steers Realty (ICF)	99	1.26
Vanguard REIT Index VIPERs (VNQ)	83.1	1.22
streetTRACKS KBW Capital Mkts (KCE)	96.3	1.21
iShares GS Natural Resources (IGE)	93.3	1.19
Data as of 04-06-06

Hot Properties
Real estate, the Energizer Bunny of asset classes over the last 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 last three years and more than 22% annualized over the last 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.

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
Fund	% of Assets w/ Fair Value Estimates	Price/Fair Value
Rydex Russell Top 50 (XLG)	98.2	0.88
streetTRACKS KBW Bank (KBE)	100	0.89
Consumer Staples Select SPDR (XLP)	100	0.90
streetTRACKS DJ Global Titans (DGT)	92.5	0.91
Vanguard Consumer Staple VIPERs (VDC)	94.4	0.91
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.