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Fund Spy

Our Take on This Year's Hottest-Performing ETFs

Tread wisely with these specialized exchange-traded funds.

90-degrees and humid. Welcome to Chicago in mid-August.

Perhaps it's heat on the brain that has us straining for metaphors, but with the dog days of summer upon us, we thought we'd run through a short list of some of this year's hottest-performing ETFs.

Overall, this has been a great year for ETFs targeting heavy manufacturing, metals, as well as emerging-markets stocks. On the flipside, internet- and homebuilder-related ETFs have gotten crushed and woe to investors who have bet against the price of crude oil or the Nasdaq 100 Index (Claymore Macroshares Oil Down (DCR) and Ultrashort QQQ ProShares (QID), respectively).

Here's our take on the five ETFs that posted the best returns through Aug. 8, 2007.

Market Vectors Steel
Year-to-Date Return: 39%

Market Vectors Steel (SLX), which tracks the Amex Steel Index, has been on a tear. As its name would suggest, the portfolio is laden with the stocks of steel producers and the miners that supply them, 33 in all. What's most notable, however, is the fund's global complexion: Foreign players soak up roughly two thirds of the fund's assets. That's been a boon of late with names like  Rio Tinto (RTP) (29% year-to-date return),  Companhia Vale Do Rio Doce (RIO) (66%),  Arcelor Mittal (MT) (54%),  Posco (PKX) (74%), and  Gerdau (GGB) (64%), which collectively account for more than half of the fund's assets, propelling returns.

  • Our Take: If you're trying to build a well-diversified, low-cost portfolio, you don't need this offering. True, many of the fund's holdings hail from emerging economies, like South Korea and Brazil, that are absent from ETFs tracking core broad-market foreign indexes, such as  iShares MSCI EAFE (EFA). Yet, we think it makes more sense to invest in emerging markets via a well-diversified basket, such as  Vanguard Emerging Markets (VWO), as it helps to diffuse the industry- and region-specific risk that many of these names court. And while the Market Vectors ETF spreads its bets across nearly three dozen stocks, it's levered to just a handful of names, all of which are tied to the vagaries of the highly cyclical steel market. We'd also caution investors who are determined to play steel as part of, say, a tactical allocation: Our research suggests that the sector is, at best, fully valued (based on our analysis of the underlying stocks, most of which our stock analysts cover).
  • Suggested Alternative: Generally speaking, we don't think that narrowly sliced ETFs, such as sector- or country-specific ETFs, are needed to build an efficient portfolio. Thus, investors need not hunt and peck around for substitutes to the Market Vectors offering, as low-cost, well-diversified funds ought to do just fine. That said, for investors who are employing ETFs as part of a sector rotation or tactical allocation scheme, it can make sense to shade the portfolio to certain attractively priced realms. While the Market Vectors fund isn't a good value, in our opinion, we're finding bargains in other areas. For instance, homebuilders have gotten the stuffing knocked out of them amid a wrenching pullback in the housing sector and an increasingly skittish mortgage market. Consequently, we're seeing values aplenty among homebuilder ETFs, with iShares Dow Jones U.S. Home Construction (ITB) and  SPDR S&P Homebuilders (XHB) topping our shopping list. (Both are priced at healthy discounts to fair value, in our analysts' estimation.)

IShares MSCI Brazil
Year-to-Date Return: 37%

IShares MSCI Brazil (EWZ), which tracks the MSCI Brazil Index, has benefited from a few factors. First, the Brazilian Real, in which most of the fund's holdings are denominated, has strengthened smartly versus the dollar in 2007. That currency tailwind accounts for roughly one third of the fund's year-to-date performance. In addition, like the Market Vectors fund, this offering is dominated by a few large holdings: Iron ore miner Companhia Vale Do Rio Doce (CVRD), integrated oil concern  Petrobras (PBR), and Brazilian bank  Banco Bradesco (BBD), which account for roughly half of the fund's assets alone, have all risen sharply.

  • Our Take: We're playing the same song: You don't need this. The fund's narrow focus makes it too difficult to use in a portfolio. If you're enticed by the fund's outsized returns, bear in mind that the success of any bet you make is predicated on a few factors. First, that the Brazilian currency--a boon for the fund of late--isn't going to be a major headwind. (Good luck handicapping those odds.) Second, that the aforementioned companies will continue to rip off big gains. That's not action we'd take, especially considering that many of the underlying holdings look overpriced based on our equity research.
  • Suggested Alternative: We've already mentioned Vanguard Emerging Markets as a viable alternative for investors seeking to add emerging-markets exposure to a well-diversified portfolio. More-aggressive investors seeking to play Latin America would do well to place their bets very selectively. For instance, while Brazil looks rich to our equity analysts' eyes, we're seeing some interesting values in Mexico, where telecom giant  America Movil (AMX), cement-maker  Cemex (CX), and beverage concern Mexican Economic Development all stand as tempting bargains. Thus, iShares MSCI Mexico (EWW), which is home to many of these names, looks like a better choice, though we'd urge even the most-aggressive investors to tread carefully there.

PowerShares Wilderhill Clean Energy
Year-to-Date Return: 33%

 PowerShares Wilderhill Clean Energy (PBW) differs from the two previous offerings in a key respect: The portfolio isn't bunched in a few holdings, as its 42-stock portfolio is spread more or less evenly, with the typical name accounting for 2% or 3% of assets. The fund tracks the Wilderhill Clean Energy Index, which is a "selection of companies that focus on greener and generally renewable sources of energy and technologies that facilitate cleaner energy." What kinds of companies are we talking about? In many cases, upstart technology and electrical equipment firms. For instance, the fund's top holding, Color Kinetics (CLRK), manufactures LED lighting systems--not that the links to clean energy are always clear-cut. To wit, semiconductor equipment giant  Applied Materials (AMAT) garners a slot in the portfolio, presumably for its role in advancing other energy-friendly technologies. The formula has worked this year, with top holdings Color Kinetics, Echelon (ELON), and Trina Solar (TSL) surging 59%, 275%, and 228%, respectively.

  • Our Take: Like any other industry fund (and clean energy is a bona-fide industry), this ETF is hardly essential to portfolio construction. True, investors committed to promoting clean-energy sources and technologies might take a shine to this fund's laserlike focus on that strand of the energy conservation movement. But even they should realize what they're buying--a collection of firms that, with a few exceptions, have yet to trench out durable competitive advantages of any kind (explaining why we've awarded "economic moats" to relatively few of the portfolio holdings that we cover). Thus, if it's the growth of this movement that you're seeking to tap, invest with a fair amount of caution.
  • Suggested Alternative: The pickins' for clean-energy enthusiasts are pretty slim. Yet, there are a few options. First, this fund's sibling, PowerShares Wilderhill Progressive Energy (PUW), aims to invest in companies that promote the more-efficient use of fossil fuels, making it a kindred spirit. What sets it apart from this offering is its valuation: The Progressive Energy fund is trading at a modest discount to our fair value estimate based on our coverage of 30 of its 47 holdings. The second option is iShares KLD Social Index (DSI), which gives socially conscious types the benefits of wide diversification (assets are spread across roughly 400 names and virtually every industry). It's also a bargain to boot, as the fund was recently trading at a 9% discount to our fair value estimate.

IShares MSCI South Korea
Year-to-Date Return: 31%

In certain respects, iShares MSCI South Korea (EWY) bears a strong resemblance to its sibling, iShares MSCI Brazil. Like that fund (and most country-specific offerings, for that matter), this ETF skews toward its top holdings, with the top 10 names accounting for roughly half of assets. Consequently, as stocks like Samsung Electronics (15% of assets), Posco (8%), and  Kookmin Bank (KB) (6%) go, so goes this ETF. This year, at least, that dynamic has worked out quite well, with Posco and  Shinhan Financial (SHG) logging nice returns. In addition, the fund has enjoyed a modest kick from a weakening dollar versus the South Korean won.

  • Our Take and Suggested Alternative: See "iShares MSCI Brazil."

PowerShares Dynamic Oil & Gas Services
Year-to-Date Return: 28%

Unlike the other ETFs on the list, which are purely passive,  PowerShares Dynamic Oil & Gas Services (PXJ) is quasiactive. It tracks a benchmark dubbed the "Oil & Gas Services Intellidex," which ranks U.S. oil and gas services stocks based on various growth, valuation, momentum, and risk factors. For all intents and purposes, however, the primary driver of absolute returns is the fund's narrow subsector focus. And, my, what a wonderful year it has been for oil and gas services stocks. Of this fund's 30 stocks, all but five have posted double-digit gains and nearly two of three have risen 20% or more.

  • Our Take: This is, for all practical purposes, a way to play a slice of the oil patch. Therefore, we see no ostensible reason for an investor to consider using this fund as a building block for a well-diversified portfolio. It's too specialized to suit all but the most ardent portfolio-tinkerers. So, the question is really whether it's worthwhile as a means of shading a portfolio to oil and gas services firms as part of a sector rotation or tactical allocation strategy. On that basis, we see little to gush over: Many of the stocks are trading at significant premiums to our fair value estimates. For instance,  Smith International (SII) is fetching roughly double our estimate of the company's intrinsic worth.
  • Suggested Alternative: If you absolutely positively can't resist betting on the oil patch, we think that iShares Dow Jones U.S. Oil & Gas Explorers (IEO) is a better choice, as that ETF was recently trading at a 13% discount to our aggregate fair value estimate.

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.

Jeffrey Ptak has a position in the following securities mentioned above: AMAT. Find out about Morningstar’s editorial policies.