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Fund Spy

ETFs: the Cheap, the Dear, and the Fairly Valued

Here's an update on funds our stock analysts would and wouldn't buy now.

A recent look at the valuations of the holdings of some domestic-equity exchange-traded funds has produced some interesting results.

Despite all you hear about the cooling (or crashing, depending on who's talking) housing market, ETFs that track homebuilders are trading well below the aggregate fair values of their portfolios, according to Morningstar's stock analysts. Furthermore, due to steep declines in hardware stocks, large-growth ETFs are trading lower than they have in a while, relative to their overall fair values. Meanwhile, the most overvalued ETFs were real estate offerings, such as  iShares Cohen & Steers Realty Majors (ICF), and energy funds, particularly iShares Dow Jones U.S. Oil Equipment Index  (IEZ), which tracks the shares of drilling gear makers.

These observations come from Morningstar's price/fair value measure, which I've written about before, but here's a quick review: Morningstar has 90 equity analysts using bottom-up analysis and dividend discount models to come up with fair values for about 1,800 stocks. For ETFs that own a lot of the stocks we cover, we roll up the fair values and market prices of those companies and compare the two numbers. The result is a ratio that should give you an idea of whether the ETFs' underlying portfolios are undervalued, fairly valued, or overvalued.

The price/fair value measure can help find diversified ETFs that look attractive. You also can use it to find sector ETFs that might be ripe for more-speculative bets, though it's best to limit those to a small portion of an already diversified portfolio. The measure, however, isn't useful for funds that own a lot of stocks Morningstar analysts don't cover. So for this article (as I have done before), I focused on the nearly 100 ETFs in which companies on Morningstar's equity coverage list make up at least 80% of the market capitalization of the underlying portfolios.

 Overvalued ETFs
FundCoverage Rate %P/FV
iShares Dow Jones US Oil Equipment Index (IEZ)85.41.47
iShares Cohen & Steers Realty Majors (ICF)99.11.27
StreetTracks Wilshire REIT (RWR)90.01.25
iShares Dow Jones US Real Estate (IYR)88.61.24
Vanguard REIT Index ETF (VNQ)85.61.23
Data as of 08-03-06

 Undervalued ETFs
FundCoverage Rate %P/FV
iShares Goldman Sachs Technology Index (IGM)95.10.84
SPDR O-Strip 97.80.83
iShares Goldman Sachs Networking (IGN)93.30.76
SPDR Homebuilders (XHB)87.20.73
iShares Dow Jones US Home Construction (ITB)84.20.67
Data as of 08-03-06

Are Builders as Bad as They Look?
This time around, iShares Dow Jones U.S. Home Construction (ITB) and SPDR Homebuilders (XHB) sported the lowest price/fair valued measures. Indeed, they were the lowest I've seen for ETFs with strong coverage rates since we started trying to value ETF portfolios like this. The portfolio's narrow focus has something to do with that. In funds this concentrated, there's not much left to buoy results and valuations when their neighborhoods take a drubbing. And homebuilders have absorbed a prodigious butt-whopping this year--falling nearly 30% on average through August 4 as worries about rising interest rates, more circumspect consumers, rising inventories, and chilling prices mount. Morningstar stock analyst Arthur Oduma thinks the market is overly pessimistic, though, and has been pounding the table for homebuilders. Some of the largest stocks in the industry, and biggest positions in the ETFs that track it, such as  Pulte Homes (PHM) and Centex  are trading below Oduma's estimate of their fair values, which already take into account weaker home sales than we've seen in recent years.

Tech Bellwether Blues
Technology ETFs, such as  iShares Goldman Sachs Technology Index (IGM), and funds that focus on mega-caps, such as  Diamonds (DIA), SPDR O-Strip , iShares S&P 100 Index (OEF), and Rydex Russell Top 50 (XLG), also looked undervalued with price/fair value measures in the 0.80s. The market has been screaming, "Show me the growth!" at tech bellwethers like Dell  and Intel (INTC) for some time, punishing them for their disappointing earnings. Our stock analysts, however, think the market has been overreacting. Tomorrow's growth darlings are unlikely to be the same as yesterday's, but beleaguered members of the old guard, such as Dell, Intel, and Wal-Mart (WMT), are still profitable, well-managed companies that currently look cheap after you consider their disappointments and competitive threats, according to Morningstar stock analysts.

That's why the most interesting opportunity revealed by the price/fair value measure may be where growth and size intersect. Many large-growth ETFs were looking almost as undervalued as the sector funds at the start of August, with price/fair value ratios under 0.90. These ETFs would give you exposure to the same undervalued assets in the technology sector and the home construction industry without as much issue and sector risk. Indeed, my favorite among the bunch, Vanguard Growth ETF (VUG), owns more than 400 stocks across a variety of sectors (it even owns a few of the homebuilders, such as Toll Brothers (TOL) and KB Home (KBH)), and it's the cheapest ETF in its category with an 0.11% expense ratio.

Rally Weary?
In the overvalued end of the market, REIT yields, after a multiyear rally, offer no more compensation to investors than less-risky 10-year Treasury issues. Lofty oil prices and the need to find more crude and gas have pushed the share prices of oil- and gas-services stocks such as Halliburton (HAL) and Schlumberger (SLB) above their fair values, according to Morningstar stock analysts. There are strong arguments for maintaining exposure to both real estate and energy. Real estate can diversify a portfolio, and the balance of energy supply and demand is likely to tilt toward the latter for some time. Yet, these are perilous places to chase returns right now and if you haven't already rebalanced your allocations to these areas, now may be a good time.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.

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