10 Attractive ETFs

Based on our equity research, the overall market is trading roughly in line with fair value. The S&P 500 Index, for example, is trading about 4% less than fair value, and the Dow Jones Industrials about 6%. But several pockets of the market trade at much steeper discounts, and one way to gain instant exposure to those areas is through ETFs.

To create the list of the cheapest ETFs you see below, we first screen for those where we have fair value estimates on at least 80% of the stocks in the portfolio (on an asset-weighted basis). We throw out any ETFs for which our portfolio dates are older than 45 days. Then we take the 10 funds with the lowest price/fair value ratios.

ETFs that focus on financial stocks dominate the list, which isn't surprising, given how our financials team has been pounding the table on the bargains they see in their sector. The cheapest, KBW Bank ETF (KBE), trades for 83 cents on the dollar, assuming of course that our fair value estimates for the underlying banks held in the portfolio are correct. It's no coincidence that Sonya Morris, who runs two ETF portfolios in our ETFInvestor newsletter, holds a position in the fund. (For more from Sonya, see her take on five of the most popular new ETFs.) Several consumer-related ETFs also dot the list, thanks to 5-star holdings such as  Time Warner ,  Home Depot (HD), and  Sears Holdings .

Cheapest ETFs
	Price/FV*	Expected Return	Average COE*	Expense Ratio
KBW Bank ETF (KBE)	0.83	18%	11%	0.35%
iShares DJ US Fin Svs Idx (IYG)	0.84	18%	11%	0.48%
iShares DJ US Regional Banks (IAT)	0.84	17%	11%	0.48%
Regional Bank HOLDRs	0.84	17%	11%	**
Retail HOLDRs	0.86	15%	10%	**
PowerShares FTSE RAFI Cons Svs	0.87	16%	10%	0.77%
PowerShares FTSE RAFI Financials	0.87	16%	11%	0.78%
Financial Select Sector SPDR (XLF)	0.88	16%	11%	0.24%
PowerShares Hi Gr Rate Div Achiev	0.88	15%	10%	0.61%
iShares DJ US Cons Svs  (IYC)	0.89	14%	10%	0.48%
Data as of 10/05/07 * Based on weighted average of underlying stocks. ** HOLDRs charge an $0.08 per share annual custody fee.

What does KBW Bank's 0.83 price/fair value ratio mean in terms of possible future returns? If we assume that stock prices migrate to fair value over a three-year period, the expected annualized return of the stocks held in this ETF is 18%. Pretty good. If we then net out the fund's 0.35% expense ratio, we still get an overall expected return well in excess of the required rate of return of the underlying stocks (11%), which is the return we feel investors should require to compensate for the riskiness of this particular pool of stocks.

Of course, you give up something for the added diversification that comes with an ETF, as opposed to buying individual stocks directly. If you cherry-picked one, two, or three individual bank stocks instead of buying the ETF, you could increase your expected return by buying the very cheapest ones. Stocks such as  Capital One (COF) (expected return of 30%),  Washington Mutual (WM) (30%), and  Bank of America (BAC) (22%) trade for much lower P/FV ratios than KBW Bank ETF's portfolio as a whole. But for investors who prefer the safety that comes with numbers, the ETF is a great option.