Finding Undervalued ETFs

We occasionally get questions about whether Morningstar provides fair value estimates for mutual fund shares--in other words, whether we offer a metric that suggests whether shares in a fund are over- or underpriced based on our analysts' fair value estimates for the equities held in the fund's portfolio. In theory this would be possible given that more than 1,000 stocks are assigned fair value estimates by Morningstar's equity analyst team. The problem is that mutual funds do not update their portfolio information each day, meaning that any fair value estimate of a fund's holdings would only be current to the most recent disclosure of its portfolio and therefore could very easily be out of date and thus inaccurate.

Exchange-traded funds, on the other hand, don't have this issue because they are required by the SEC to disclose their portfolios every day, making it possible for Morningstar to sync up an ETF's equity holdings with our analysts' fair value estimates. We can provide a fair value estimate for many ETFs on their quote pages based on the weightings of equities within the portfolio. By using these ETF fair value estimates, Morningstar readers can see whether a fund is trading at a discount or a premium to the value of its underlying holdings as estimated by our equity analysts.

Currently the stock market is fairly valued, according to Morningstar's equity analysts, and as a result, many ETFs--the majority of which are index-based and many of which track wide swaths of the market--are more or less fairly valued as well. For investors who are less concerned about finding undervalued ETFs and more concerned with finding ETFs that do their job well and charge reasonable fees,  this list of our ETF Analysts' Favorites is a logical starting point. But for those seeking equity ETFs whose holdings are at least somewhat undervalued, another place to look is Morningstar's  ETF Valuation Quickrank page.

The tool allows Premium members to search alphabetically or by category for ETFs based on different criteria, including price/fair-value ratio. The lower this ratio, the greater an ETF's holdings are discounted relative to our analysts' fair value estimates. Only ETFs in which at least two-thirds of assets are covered by Morningstar equity analysts are included in the tool, so ETFs that invest more heavily in stocks that are not under coverage--including some small-cap and foreign stocks--are not included.

A scan of the list finds very few screaming bargains--the most undervalued ETF on the list is an extreme niche investment,  Market Vectors Steel ETF (SLX), which tracks an index of 26 publicly traded steel industry firms and which currently sells in the low- to mid-$40s despite a fair value estimate of around $64. The majority of ETFs on the list are trading within about 10% of their fair value estimates, with some of the deeper discounts in sector funds (fair value estimates for sectors can be found on the Market Fair Value page). A few of these ETFs are shown below. To see the full list, Premium members can visit the  ETF Valuation Quickrank and sort by Price/Fair-Value rating.

Sector ETFs such as these can provide good diversification within an industry, especially for investors who prefer to bet on a basket of stocks as opposed to just one. That said, sector ETFs also can be fairly concentrated in a few big names and are not as diversified as funds that invest in the broader market, which is why they are best as supporting players in a portfolio rather than as core holdings. Before investing in a sector ETF, it's also a good idea to check whether you already have exposure to the industry through a broad market ETF--for example, by checking the sector weightings of the S&P 500 if you own a fund that tracks it.

 Market Vectors Oil Services ETF (OIH)
Monday's Fair Value Estimate: $46.95
Monday's Closing Price: $42.16
Price/Fair Value: 0.90
Rather than hold large energy producers such as  ExxonMobil (XOM) and  Chevron (CVX), this ETF instead holds companies that provide drilling and other services to the industry.  Schlumberger (SLB) (currently trading in 3-star range) and  Halliburton (HAL) (currently at 4 stars) together make up 30% of the portfolio in this highly concentrated offering. The fund invests at least 80% of assets in stocks in the market-cap-weighted Market Vectors US Listed Oil Services 25 Index, with about one quarter of holdings in Europe. The ETF's performance is tied to crude oil and natural gas prices, making it highly cyclical and volatile. Investors should consider this ETF as a satellite holding only.

 iShares Dow Jones US Technology (IYW)
Monday's Fair Value Estimate: $80.21
Monday's Closing Price: $73.07
Price/Fair Value: 0.91
This ETF tracks a cap-weighted index of about 140 technology stocks included in the broad-market Dow Jones U.S. Index. The fund's high-quality, concentrated portfolio is dominated by large-cap tech companies with sustainable competitive advantages (moats), including  Apple (AAPL) (18%),  IBM (IBM) (9%),  Google (GOOG) (9%), and  Microsoft (MSFT) (9%). (Apple and Microsoft currently trade in the 4-star range, although our equity analysts believe the tech sector as a whole is slightly overvalued.) About 80% of holdings fall in the large-cap realm. As a sector fund, this ETF is suitable as a satellite holding, but investors should be aware that it is highly correlated to the S&P 500, so it has limited appeal as a diversification tool for those already invested in the index.

 SPDR S&P Metals & Mining (XME)
Monday's Fair Value Estimate: $49.05
Monday's Closing Price: $40.46
Price/Fair Value: 0.82
For investors looking for U.S.-based commodities exposure and unafraid of a bumpy ride, this ETF--which tracks the equal-weighted S&P Metals and Mining Select Industry Index of firms that produce coal, aluminum, steel, gold, copper, and iron--might make a suitable satellite holding. Because it is limited to U.S.-based companies, however, the portfolio is less diversified than other mining sector ETFs that include industry leaders based in other countries. The index's equal weighting and the fund's U.S. bent result in a portfolio with 60% of holdings in small caps.

Fair value estimates as of Monday's closing; portfolio data as of March 22.