Searching for Undervalued ETFs

ETFs are often used as building blocks for a diversified portfolio, or as a low-priced access vehicle to asset classes such as fixed income, emerging markets, and commodities.

But ETFs are also useful for capitalizing on sector trends, as there are currently more than 300 sector ETFs, including the popular Sector SPDRs, as well as subsector ETFs such as  SPDR S&P Homebuilders (XHB),  Market Vectors Steel , and  iShares PHLX SOX Semiconductor Sector (SOXX).

Morningstar's equity research team covers 1,700 companies and is a great resource for investable ideas for ETF investors. In this article, we highlight some ETFs that would be suitable investments to play some of the sector trends culled from recent Stock Strategist Industry Reports, Stock Strategist articles, and our analysts' recently published Quarter-End Insights.

Biotech
In the Health-Care Quarter-End Insights, health-care team leader Alex Morozov writes that M&A in the sector will remain strong in 2011, after 11 announced or completed $1 billion-plus deals in 2010. Big Pharma will likely be the main acquirers, given their strong balance sheets and impending major patent losses. The health-care team's top takeout picks include  Biogen-Idec (BIIB), which has a multiple sclerosis drug with strong revenue growth potential and a number of late-stage pipeline candidates.

Other top picks include development-stage firms  Seattle Genetics  and  Human Genome Sciences . While investors can buy these particular stocks to make very specific bets, a biotech ETF would allow investors to spread out their bets across a couple dozen biotech firms. And for a sector as volatile as biotech, an ETF reduces single-stock risk on the downside, but on the upside as well.

To find biotech ETFs, we used the Morningstar ETF screener to identify funds with exposure to BIIB, SGEN and HGSI. We also scanned the list of Morningstar ETF Analyst Reports, sorted by category, to find the biotech funds among the "Health Care" ETFs. There are four ETFs that look like suitable options.

  # of Holdings % Asset in Top 10 Avg Mkt Cap ($Bil) Annlzd 3-Yr Ret (%) 3-Yr Std Dev Weighting Method iShares Nasdaq Biotechnology (IBB) 126 45 5.8 10.0 22.2 Mkt-cap SPDR S&P Biotech (XBI) 47 31 2.7 8.1 25.8 Equal PowerShares Dynamic Biotch&Gen (PBE) 31 48 3.0 9.1 24.1 Fndmntl First Trust NYSE Arca Biotech Index (FBT) 20 53 4.8 22.1 29.4 Equal Data as of 3/31/11.

 
In our opinion, an equal-weight ETF is an attractive option, as smaller-cap names may be more likely takeout candidates than large-cap names. In an equal-weight fund, smaller-cap names have a bigger impact on the fund's performance than they would in a market-cap-weighted fund. At the same time, greater exposure to small caps also means more volatility, as many of these firms are development-stage companies, some of which may never bring a product to market.

There are two equal-weight biotech funds-- SPDR S&P Biotech (XBI) and  First Trust NYSE Arca Biotech (FBT). Out of XBI's 47 holdings and FBT's 20 holdings there are 14 holdings in common. FBT has strongly outperformed its peers over the last three years thanks to more concentrated exposure to companies that saw strong price appreciation after getting taken out, winning approval for a drug, or signing a major partnership. Out of the four ETFs to play the M&A trend in biotech, we would pick FBT, given its equal weight portfolio, and its relatively larger exposure to BIIB and HGSI, at around 5% each.

Coal
Among the recent Stock Strategist Industry Reports, the article Coal Will Benefit from Japan's Nuclear Near Miss has a few investment ideas that could work well via an ETF. Analyst Michael Tian's basic thesis is that coal will see increased global demand over the near and medium term due to an anticipated slowdown in new nuclear power following the nuclear disaster in Japan. More specifically, Michael writes that strong demand for coal in Asia should benefit companies with assets in that region.

To find coal ETFs, we again turn to the ETF screener, and search for ETFs with significant exposure to a large coal companies, such as  Peabody Energy Corporation . There are two coal-focused ETFs--PowerShares Global Coal  and Market Vectors Coal . By checking the portfolios of both ETFs, we can see that PKOL has a higher percentage of its portfolio in companies domiciled in Australasia and Asia Emerging (57%) relative to KOL (39%). However, we note that some of the larger coal mining companies (such as Peabody, which is domicled in the U.S.) have assets outside their home country, so this data point does not tell the whole story.

Interestingly, while the performance of the two ETFs had been highly correlated, the performance started to diverge in March, as PKOL has exposure to uranium mining companies, whereas KOL does not. Given the uncertain outlook for nuclear in the near and medium term, we think KOL would be an obvious choice over PKOL.

Agriculture Commodities
Another article that caught our eye was Jeffrey Stafford's Rising Commodity Prices Help Agriculture, Harm Chemicals. Adverse weather conditions around the world have affected supplies, driving up crop prices. Longer term, rising standards of living in the developing world will drive healthy demand growth.

One way to play this trend is to invest in companies that supply crop inputs, such as fertilizer, seed, and crop chemicals. Using the Morningstar ETF Screener, we find there are three ETFs that fit the bill--PowerShares Global Agriculture ,  Market Vectors Agribusiness (MOO), and Jefferies TR/J CRB Global Agriculture . The holdings of these funds are fairly similar, so we would pick MOO, which is the most liquid, and has the lowest expense ratio of the three. Top holdings in MOO include many of the high-flyers from 2007 and 2008, such as  Monsanto , and fertilizer input producers  Potash Corp (POT),  Agrium , and  Mosaic (MOS). While fertilizer firms certainly benefit from growing demand for food and rising agriculture commodity prices, they can also face higher input costs and oversupply by competitors, which will drive volatility in the performance of these companies, and these ETFs.

Besides equity ETFs, investors can also get exposure to rising agriculture commodity prices by investing in ETFs or ETNs whose performance is linked to the performance of agriculture commodity futures. We cover two agriculture commodity ETNs-- PowerShares DB Agriculture ETF (DBA) and  iPath DJ-UBS Agriculture TR Sub-Index ETN (JJA)--both of which track a basket of agriculture commodities futures such as soybeans, corn, wheat, and livestock.

The advantage of investing in a futures-based product over an equities-based product is that the former provides better portfolio diversification (agriculture commodities futures have very low correlations to equities) and lower volatility. The three-year trailing standard deviation for DBA, JJA, and MOO are 22.8, 28.3, and 33.7. Our commodities ETF analyst Abraham Bailin prefers DBA over JJA, as DBA employs an optimum yield indexing methodology, which attempts to maximize gains and minimize losses from the roll yield.

Financials
Finally, we can also search for investment ideas by screening for ETFs with low price/fair value ratios. The fair value estimate of an ETF is based on the asset-weighted fair value estimates of its underlying stocks, as calculated by Morningstar equity analysts.

At this time, the ETFs with the lowest price/fair value ratios are primarily health-care and financial ETFs, two sectors that have been weighed down over the last year or two by regulatory uncertainty. Among the top 10 ETFs with the lowest price/fair value ratios, we like  SPDR KBW Bank (KBE). Many of the top holdings in this fund are "moaty" banks with strong capital positions.

In addition, banks that have announced dividend increases after the last Fed stress test account for almost 50% of KBE's portfolio, and some of the largest holdings, including  J.P. Morgan Chase (JPM),  Wells Fargo (WFC),  U.S. Bancorp (USB), and  Bank of NY Mellon (BK) also announced stock buybacks. While these new dividend rates are still low relative to the pre-crisis days, the Fed did state that banks will be allowed to submit plans quarterly should they want to further increase their dividends. We could see some backs announce additional dividend increases later this year or next year.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock Asset Management, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.