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Fund Spy
Find ETFs at bargain prices
Investors can pick from exchange-traded funds covering most every market sector. But which ones are worth the price? Morningstar takes a look.
By Morningstar
It's been about seven months since we first used Morningstar's ETF price/fair value measure to take the temperature of the market and various sectors. As 2005 draws to a close, the song remains the same: Energy and basic-materials ETFs still look expensive, while consumer-goods and financial ETFs look undervalued.
Before we tackle the specifics, let's review the mechanics of the price/fair value ratio. This statistic is Morningstar's way of tapping the research of its 85 in-house equity analysts who research and estimate fair values on more than 1,600 stocks to help evaluate the attractiveness of ETF fund portfolios. The measure basically tries to offer a bottom-up assessment of whether an ETF portfolio is cheap or expensive by gauging whether its holdings, on average, are trading above or below their Morningstar fair value estimates.
To get the price/fair value ratio, we calculate the market value of all the holdings in the ETF for which we have fair-value estimates. Then we use the fair value estimates of those stocks to calculate what we believe is the fair value of the same portfolio. Finally, we compare the two numbers and calculate the percentage premium or discount of the market value relative to the fair value estimate. When that difference is expressed as a ratio, a number more than one means the ETF's portfolio is overvalued; less than one indicates it is undervalued.
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Morningstar does not estimate a fair value for every stock an ETF might own, so the relevance of the results of the price/fair value depends on how many stocks in a given portfolio have received a fair-value estimate and the percentage of that portfolio's assets these stocks represent. Our coverage is pretty comprehensive for the vast majority of domestic large-cap ETFs: Morningstar analysts have assigned fair value estimates to stocks representing 75% or more of the asset values of most ETFs in that space.
Broad market vs. large growth
At the end of November 2005, the price/fair value ratio showed broad-market index ETFs were fairly valued. Vanguard Total Stock Market VIPERs (VTI, news, msgs), iShares Dow Jones Total Market (IYY, news, msgs), StreetTracks Total Market (TMW, news, msgs) and iShares Russell 3000 Index (IWV, news, msgs) all had fair values within shouting distance of the total market values of their holdings.
| Broad-market ETFs | | ETF | % of Assets
w/ FV estimates | *Price/fair value | | iShares Russell 3000 Index (IWV, news, msgs) | 90.0 | 0.99 | | iShares DJ US Total Market Index (IYY, news, msgs) | 93.3 | 0.99 | | Vanguard Total Stock Market VIPERs (VTI, news, msgs) | 88.0 | 0.99 |
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Data as of Dec. 9, 2005.
*Price/fair value number over 1 indicates the ETF's portfolio is overvalued; less than 1 indicates it is undervalued.
Surprisingly, large-cap growth ETFs looked fair, too. Given the way large-growth stocks have lagged the rest of the market in recent years, one might expect ETFs focused on them, such as Vanguard Growth VIPERs (VUG, news, msgs), iShares S&P 500/Barra Growth Index (IVW, news, msgs) and StreetTracks Dow Jones Wilshire Large Cap Growth (ELG, news, msgs), to look relatively undervalued.
Despite this group's underperformance, however, the funds actually are mixed bags valuation-wise. There are some attractively priced stocks in there, such as software giant Microsoft (MSFT, news, msgs), heart-device maker Boston Scientific (BSX, news, msgs) and computer maker Dell (DELL, news, msgs). To even things out, though, there are a good number of richly priced shares, such as Internet search firm Google (GOOG, news, msgs), health insurer UnitedHealth Group (UNH, news, msgs) and oil-services company Schlumberger (SLB, news, msgs), which have all enjoyed very strong runs in the past year.
Energy
As they were in the spring, the differences are more obvious among sector funds. Energy ETFs, which were the most overvalued funds when we first applied the price/fair value measure in May 2005, still look overvalued. Though energy prices moderated somewhat in the fall and took some of the wind out of the stocks' sails, the energy sector is still up smartly for 2005. Large integrated oil companies, such as Exxon Mobil (XOM, news, msgs) and BP (BP, news, msgs), which usually gobble up a lot of natural-resources ETFs' assets, look neither cheap nor expensive. But oil-services companies, such as Schlumberger and Halliburton (HAL, news, msgs), as well as refiners and exploration and production companies, such as Valero Energy (VLO, news, msgs), are way over their fair values after posting eye-popping returns in the past year.
These stocks are big components of iShares Goldman Sachs Natural Resources (IGE, news, msgs), Energy Select Sector SPDR (XLE, news, msgs), Vanguard Energy VIPERs (VDE, news, msgs) and iShares S&P Global Energy Sector (IXC, news, msgs). Each of these ETFs was among the most overpriced large-cap ETFs at the end of November 2005, with their shares trading about 20% higher than the value of their underlying components.
| Overvalued ETFs | | ETF | % of Assets
w/ FV Estimates | *Price/fair value | | | | | iShares GS Natural Resources (IGE, news, msgs) | 96.5 | 1.29 | | Energy Select Sector SPDR (XLE, news, msgs) | 100 | 1.24 | | Vanguard Energy VIPERs (VDE, news, msgs) | 94.1 | 1.23 | | iShares S&P Global Energy (IXC, news, msgs) | 64.7 | 1.22 | | iShares DJ US Energy (IYE, news, msgs) | 99.3 | 1.20 |
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Data as of Dec. 9, 2005.
*Price/fair value number over 1 indicates the ETF's portfolio is overvalued; less than 1 indicates it is undervalued.
Materials
Robust global demand for copper, gold, coal and other commodities has boosted performance and valuations of mining and other hard-asset stocks, such as Phelps Dodge (PD, news, msgs), Newmont Mining (NEM, news, msgs) and Peabody Energy (BTU, news, msgs). That, in turn, has kept the prices of basic-materials ETFs -- iShares Dow Jones US Basic Materials (IYM, news, msgs), Vanguard Materials VIPERs (VAW, news, msgs) and Materials Select Sector SPDR (XLB, news, msgs) -- above their fair values.
Technology
A glance at broad technology ETFs, such as Technology Select Sector SPDR (XLK, news, msgs) and the Vanguard Information Technology VIPERs (VGT, news, msgs), reveals a fairly valued sector. Drill down, however, and you find bigger disparities. ETFs focused on chip and communications-equipment makers, such as iShares Goldman Sachs Networking (IGN, news, msgs) and iShares Goldman Sachs Semiconductor (IGW, news, msgs), were about 15% overvalued on Nov. 30. Speculative names, such as network chipmakers Marvell Technology (MRVL, news, msgs) and Broadcom (BRCM, news, msgs), were trading far above their fair values. Meanwhile, uncertainty about information technology spending and the product cycles of individual companies has restrained the performance and valuations of software stocks in iShares Goldman Sachs Software Index (IGV, news, msgs). Some of its biggest components -- Microsoft, Oracle (ORCL, news, msgs) and Symantec (SYMC, news, msgs) -- were trading at steep discounts to their fair values, which helped make the software ETF look undervalued as well.
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