The Fundamentals of ETFs—with a Twist

02/07/2008 12:00 am EST

Focus: ETFs

Jeffrey Ptak

Director of Exchange Traded Securities, Morningstar, Inc.

Jeffrey Ptak, director of exchange traded securities at Morningstar, offered some tips on evaluating exchange traded funds using fundamental analysis, with an emphasis on intrinsic value…

Jeffrey Ptak told attendees that exchange traded funds (ETFs) are similar to indexed mutual funds but with important differences, including the fact that they are traded on an exchange, they have intraday liquidity and offer the flexibility to short or buy on margin.

Last year, almost 300 new ETFs were launched, nearly doubling their universe. And with so many to choose from, investors need to be selective. Ptak believes that relying on fundamental analysis is the best way to find good performers, especially since so many ETFs have not been around long enough to establish track records. And because ETFs are securities, it’s not difficult to apply securities research to them.

Ptak suggests that investors seek lower-cost providers and utilize fundamental analysis in one of two ways:

1. Build a portfolio based on strategic asset allocation, establishing the risk/reward profile that is best suited to your needs. Analyze the ETFs’ costs, tax efficiency, and performance—but don’t let performance influence you unduly.
2. Look for market beaters by seeking ETFs that are trading at a discount to their intrinsic value—the strategy employed by great investors such as Warren Buffett and his mentor Benjamin Graham.

This is the approach that Morningstar takes. To determine a business’s intrinsic value, Morningstar emphasizes cash flows over an extended period of time and competitive advantages, including a wide “moat,” which includes things like intellectual property rights that may keep competitors at bay.
Ptak also uses a systematic method of evaluating risk, determining if the ETF’s holdings are well-diversified with low correlations, so investors can get the most mileage from their diversification.
In the very near future, Morningstar will begin including a “fair value” rating on 100 of the ETFs it follows, which will incorporate a risk rating based on the equities in the ETF portfolio. The riskier the holdings in the ETF, the greater the discount will be. For example, energy ETFs may be considered higher risk and may come with a 20% discount, whereas low-risk sectors may be tagged with an 8% discount and moderate-risk, a 15% discount.

Right now, Morningstar’s analysts are seeing good value in large-capitalization Russell 1000 shares, particularly in the financial and consumer discretionary sector. They are very bullish on the home builders, of all things, he added.

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