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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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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.

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