Morningstar
submits:
By Paul Justice
Imagine for a moment that you timed the market brilliantly,
exited stocks back in September 2008, and re-entered the market
exactly one year ago. Chances are, with just about any stock mutual
fund or exchange-traded fund you purchased, you've done better than
you would have by simply holding cash. The decision to simply enter
the equity market paid off in spades. But now, perhaps, you're
feeling like your luck has run its course. You've ridden this horse
long enough, and now it's time to jump onto a fresh set of
legs.
Alternatively, imagine that you actually stayed in the market
through the turmoil of 2008 and the subsequent rise of 2009 and the
last four months. You feel much better now than you did 16 months
ago, but you are still down a material margin. If this describes
your situation, chances are that you feel like you should continue
to stay the course, because you need to make up those losses.
In either scenario, you are letting your emotions get the best
of you. Regardless of whether you entered the market a year ago,
three years ago, or three decades ago, your investment performance
alone should not dictate your investment decisions today. After
all, investors who entered the market at any of those three periods
could have the exact same portfolio today, even if they have
differing perspectives as to how well those funds have treated
them.
If you have a solid asset-allocation strategy, the solution is
simple: Only rebalance your portfolio when absolutely necessary
(your risk tolerance or investment horizon has changed), which may
include selling a portion of one position to add to another.
Perhaps this Zen-like state of portfolio maintenance is too benign
for you. (
It should not be
.)
Even if you are only talking about the more tactical "satellite"
portion of your portfolio, selling simply because the market has
risen is a bad idea. Not only will you incur transaction and
unnecessary tax costs, you will now have the chore of reallocating
that capital to a better idea.
Now, you could take the momentum approach and buy the fund that
outperformed yours over the past year, but chasing performance is
hardly a formula for success over the long haul. Alternatively, we
suggest using some simple sorts on the
Morningstar ETF Screener
to give you a better decision-making basis.
In this example, we've limited the sort to two simple criteria.
First, we sorted by funds that have returned more than the S&P
500 over the past year, so we selected Market Return 1 Year from
the Performance criteria dropdown menu. We then set the range to
returns ranging from 40% to 300%. Then, we added the Price/Fair
Value metric from the Valuation criteria and set our criteria to a
range between zero and one. The end result: Our analyst staff finds
there are several funds that both have outperformed the domestic
large-cap market over the past year and that are still undervalued
in aggregate. Below is a summary of five such funds that, if we
already owned them, we wouldn't part ways with just yet.
iShares MSCI EAFE Index
(
EFA
)
One-Year Return: 42.2%
P/FV: 0.87
This fund is the biggest and best-known ETF tracking the most
established foreign large-cap index around, and it is still one of
the best choices for a core foreign-stock holding. Giant
multinational companies dominate the MSCI EAFE Index, and their
global sales and production strongly resemble those of the
U.S.-based multinationals that dominate the S&P 500.
Historically, the MSCI EAFE Index has had only about a 0.75
correlation with U.S. equities, but that has risen to 0.80 over the
past five years. Given the global reach of these companies, we
expect these correlations to remain high even if economic
"decoupling" occurs and other developed economies start to grow at
different rates from the United States. However, these companies
still provide a very safe and stable investment in global growth,
along with some diversification benefit through currency effects
and somewhat different geographic reach.
iShares MSCI Canada Index
(
EWC
)
One-Year Return: 52.8%
P/FV: 0.95
This single-country fund has a strong cyclical orientation. The
top three sectors include financials (which accounts for 35% of the
portfolio), energy (27%), and materials (19%). Risk-averse
investors should note that this fund has a high exposure to
commodities through its holdings in oil producers and gold miners.
There are some diversification benefits to holding EWC. Materials
and energy companies account for about 45% of EWC's holdings, and
rising commodity prices for export products such as oil, gold, and
other minerals are contributing to the rise in the Canadian dollar.
Investors concerned about a falling U.S. dollar could invest in EWC
to gain exposure to non-U.S. dollar assets.
Vanguard Total Stock Market ETF
(
VTI
)
One-Year Return: 43.2%
P/FV: 0.96
This ETF covers the entire U.S. stock market for a rock-bottom
cost of 0.09% a year, and it provides investors with one of the
finest core holdings in the ETF universe. This fund tracks the MSCI
U.S. Broad Market Index, which includes nearly all publicly traded
domestic stocks. Although it is impossible to own all the smallest
of the small- and micro-cap companies swilling around the bottom of
the U.S. market, this Vanguard fund makes a valiant effort, holding
more than 3,300 different stocks in its attempt to replicate the
index. By investing 3%-5% in the very riskiest, most promising,
tiniest stocks, this fund provides diversification beyond that of
most broad-market ETFs, which should help long-term returns even if
it slightly raises shorter-term risks.
iShares Dow Jones US Oil & Gas Ex Index
(
IEO
)
One-Year Return: 41.9%
P/FV: 0.96
Given its extremely narrow theme focus, this thematic ETF should
be treated as a satellite specialty holding to complement a
diversified portfolio, albeit one that could be held for several
consecutive years. Unlike vertically integrated oil companies like
ExxonMobil (
XOM
) and Chevron (
CVX
), the companies held by this fund are almost entirely focused on
the businesses of exploration and production of oil and natural
gas, and their revenues are split almost equally between the two.
We find it curious that oil refiner Valero (
VLO
) is a holding, but this fund has little exposure to midstream
assets, such as refining, pipelines, and retail marketing. This
gives the fund more leverage to oil and gas prices and less revenue
diversification than oil- and gas-themed funds with sizable
holdings of large integrated energy companies.
iShares Nasdaq Biotechnology
(
IBB
)
One-Year Return: 41.2%
P/FV: 0.99
This ETF offers exposure to the highly uncertain but potentially
promising prospects of the biotech industry. The fund tracks
roughly 130 biotech firms that are listed on the Nasdaq and have
market caps of at least $200 million. Suffice it to say that there
aren't many Johnson & Johnsons (
JNJ
) or Pfizers (
PFE
) in that cohort: The fund invests nearly one third of assets in
small-cap names that are plying innovative techniques to research,
develop, and commercialize various drugs targeting certain diseases
or therapeutic niches. In our view, the biotech industry is less
susceptible to government intervention than are other health-care
subsectors--such as hospital operators or MCOs, for instance. In
any case, we think an ETF is the appropriate tool for investing in
this notoriously volatile subsector. To be sure, one drug's odds of
success are typically unrelated to another's. We like the
diversification among individual firms that this fund offers, which
helps diffuse single-stock risk.
Disclosure:
Morningstar licenses its indexes to certain ETF and ETN providers,
including Barclays Global Investors ((
BGI
)), First Trust, and ELEMENTS, for use in exchange-traded funds and
notes. These ETFs and ETNs are not sponsored, issued, or sold by
Morningstar. Morningstar does not make any representation regarding
the advisability of investing in ETFs or ETNs that are based on
Morningstar indexes.
See also
How a Market Decline Affects ETF Trading: The Case
of JNK
on seekingalpha.com