Beating the Market with ETFs

For some of you, a market return simply won't do. Instead, you invest in ETFs with the goal of beating the pants off the market. There's nothing wrong with that--we think there's plenty of money to be made from opportunistic investments in stock ETFs. In fact, we recently published a piece--"ETFs on our Buy List"--that tallied up some of the best bargains we're seeing.

But it requires patience and discipline, qualities that imbue Morningstar's approach to choosing market-beating ETFs. Here's a primer on how we pick ETFs that we think will best the market, along with some tips for you to consider as you conduct your own research.

A Fundamental(s) Question
What many investors forget is that an investment in a stock ETF isn't a wager on the value the market places on a piece of paper. It's an ownership stake in dozens, if not hundreds, of underlying businesses. Thus, we think the key to successful, market-beating ETF investing is an unerring focus on long-term business fundamentals.

But what does that mean? If an ETF investment gives you a stake in numerous businesses, the value of your investment should turn on the intrinsic worth of those firms. For instance, if the market is fairly valuing those businesses, then you're getting your money's worth. On the other hand, if the market is significantly undervaluing those firms, then you're getting an opportunity to buy in at a cut-rate price, and vice-versa for overvalued businesses.

Where the Rubber Meets the Road
You're probably wondering how this helps you beat the market. If we assume that the market, for all of its short-term gyrations, is efficient over the long haul, then we would expect the prices of assets to eventually converge to their intrinsic values. Thus, if the market is bidding down various businesses, perhaps because sentiment has turned sharply negative, but the intrinsic worth of those firms hasn't changed one iota, we'd expect the market to eventually see the error of its ways and push up the prices of those businesses to a level that approximates fair value.

When you invest in firms that the market has mispriced in this fashion, you should reap a tidy return when price converges to fair value, beating the market in the process. This calculus holds for an ETF just as it does for a single-stock investment, the only difference being that you own stakes in multiple businesses rather than a single one. (For a straightforward illustration of this concept in practice, see our recent piece, "We See a 14% Return in the S&P 500's Future.")

Not surprisingly, we're seeing bargains galore among financial and homebuilder-focused ETFs, as those areas have gotten crushed recently.  KBW Bank ETF (KBE),  iShares Dow Jones US Financial Services (IYG), and iShares Dow Jones US Home Construction (ITB) are our favorites at the moment.

Valuing ETFs (with a Little Help from Your Friends)
The question that naturally arises is: How on earth am I supposed to estimate the value of  iShares S&P 500 Index (IVV) when it spans hundreds of businesses? And even if I could get my arms around the holdings of a less sprawling fund, like a sector ETF, how do I estimate the value of those businesses?

In a nutshell, that's where we come in: We have more than 100 equity analysts covering 2,000-plus stocks spanning numerous industries and geographic locales. As such, our analysts cover substantially all the portfolio holdings of nearly 250 stock ETFs.

What's more, our analysts estimate the fair value of each stock they cover based on the rigorous analysis they conduct into company fundamentals. To estimate a firm's fair value, our analysts conduct extensive fundamental research, examining the business' competitive profile, the durability of any advantages it might boast, and the economics of the markets in which it operates.

We can harness this comprehensive research to place a fair value estimate on a stock ETF. For instance, if an ETF holds 20 stocks and our analysts have placed fair value estimates on every last one of them, then the ETF's fair value is more or less the weighted average of the stocks' fair values. For instance, as of Friday, Dec. 7, 2007, our analysts estimated  iShares S&P 100  (OEF) was worth $78.20 per share.

Separating the Wheat from the Chaff
We can begin to evaluate an ETF's attractiveness by comparing its market price with our fair value estimate. If the fund is trading meaningfully below our fair value estimate, then it has the makings of a bargain. By contrast, if it's trading at a premium to our fair value estimate, we'd probably take a pass.

End of story? Not quite. Our analysts base their forecasts on assumptions that they make about the growth, profitability, and competitive positioning of the firms they're analyzing. Because all of these assumptions are uncertain to varying degrees, we want to afford ourselves a margin of error when we invest. In that way, if our fair value estimates proves too rosy, we're not necessarily left in the lurch.

With that in mind, we probably wouldn't pound the table for an ETF trading at a 1 or 2 percentage point discount to our fair value estimate, such as  iShares Russell 1000 Growth (IWF). Instead, we'd seek a larger discount to fair value, with that extra cushion protecting us should our fair value estimate end up being wrong. You'd find that in an ETF like WisdomTree Low P/E (EZY), which was recently trading at a 12% discount to fair value.

Important Themes
You're likely to hear us harp on a few recurring themes--company quality (i.e., "economic moat"), business risk, portfolio diversification, and cost. All of these factors impact the fair value estimate that we place on an ETF and the margin of safety we demand when investing in it..

� Company Quality - High-quality firms boast intractable competitive advantages that offer economic benefits to shareholders for years and years. We refer to these sorts of advantages as "economic moats." The wider a firm's moat, the more defensible its advantages and, thus, the higher its quality.

What makes a moat? Maybe it's scale in an industry where cost leadership is paramount ( Anheuser-Busch (BUD)). Or barriers to entry like intellectual property protection ( Abbott Laboratories (ABT)) and massive capital outlays ( Bank of America (BAC)). In today's information age, network effects, which bind customers to a system or marketplace by sheer virtue of the critical mass those networks have attained, increasingly form the basis for moats ( Chicago Mercantile Exchange (CME)). And in still other cases, good old fashion branding does the trick ( Procter & Gamble (PG)). The common thread in these cases is that the moat keeps rivals at bay.

Thus, think of stock quality as the trait that most directly influences an ETF's intrinsic worth. In that sense, blue-chip-heavy ETFs like  Rydex Russell Top 50 (XLG)--which invests the bulk of assets in wide-moat bellwethers such as  Cisco Systems  (CSCO) and  Johnson & Johnson (JNJ)--deliver the biggest bang for your buck. On the flipside, you'll find precious little quality in funds like iShares Dow Jones U.S. Oil Equipment (IEZ), which is home to numerous capital-intensive, commodity-sensitive firms in the oil patch, many of which lack moats.

For more on moats and ETFs, see my colleague Sonya Morris' recent article, "Eight Cheap ETFs Loaded with Wide-Moat Stocks."

� Business Risk - Our analysts assign every stock that they cover to one of four business-risk buckets--below-average, average, above-average, or speculative. The more uncertain our analysts' cash-flow forecasts, the higher the risk rating we're likely to assign to the company concerned, and vice versa.

The riskier our analysts consider a firm, the greater the margin of safety--that is, the discount to fair value--they'll demand before recommending an investment in the stock. The same basic principle holds for an ETF as well. If the portfolio is crammed with risky energy-related stocks, we're likely to require a meaningfully larger margin of safety than we would for, say, consumer-staples ETF.

� Portfolio Diversification - It sounds obvious, but diversification across stocks and industries is a surefire way to tamp volatility. That principle is especially evident in very turbulent areas. For instance, given the boom/bust nature of the biotech business, investments in single biotech stocks are usually fraught with risk. But a funny thing happens when you throw a bunch of biotech names into a portfolio: Volatility falls dramatically.

So what's the rub? While we certainly want to pay attention to the margins of safety we're placing around an ETF's individual holdings, we also have to evaluate the level of portfolio diversification in deciding upon an appropriate margin of safety for the fund. The upshot is that we're typically demanding an 8% discount to our fair value estimate before recommending a broadly diversified ETF like the  SPDRs (SPY), and a 15%-plus discount for sector funds.

� Cost - While an ETF's annual expenses might seem to pale in comparison to the potential rewards the fund offers, they're important nonetheless. Every basis point in expenses represents an additional hurdle that your investment must clear. All things being equal, if given the choice of two identical, or at least highly similar, ETFs, it's a no-brainer: Pick the fund that has the lower annual expenses.

Morningstar ETFs 150
If you're intrigued by what you'd read thus far, keep an eye out for the 2008 edition of Morningstar ETFs 150, Morningstar's annual reference guide to all things ETF. This year's book, which should hit bookshelves in January 2008, is chock-full of research on some of the largest and most actively traded ETFs around, including analyst reports that touch on many of the themes described above.