Standout new ETFs for beating the market and building portfolios.
By Jeffrey Ptak, CFA | 01-02-08 | 06:00 AM | Email Article

At times in 2007, it seemed like hardly a day went by without another ETF making its debut. For good reason, it turns out: 290 ETFs launched last year, a pace that translated to more than one new ETF per trading day. All told, the total number of ETFs nearly doubled in 12 months!

Jeffrey Ptak, CFA, is head of global manager research for Morningstar.

That growth presents a practical challenge: How to sift through all of these new funds to find the best of the bunch, a task made more daunting by the absence of long-term track records or other evidence that would prove the funds' mettle.

With that in mind, we've canvassed the list of new ETFs and hand-picked our favorites. We've broken our short list into two categories--ETFs likely to whet the appetites of investors trying to beat the market (Market-Beating ETFs) and others better suited to investors seeking potential building blocks for a portfolio (Portfolio Building Blocks).

Market-Beating ETFs

Vanguard Mega Cap 300 Value Index ETF 
For a while now we've been pounding the table for high-quality stocks. That case looks stronger than ever lately, as the typical wide-moat stock that we cover was recently trading at a 13% discount to our fair value estimate, versus 7% and 6% discounts for the median narrow- and no-moat stocks, respectively. There are already a number of ETFs that serve as good ways to bet on wide-moat stocks, such as  Diamonds Trust  and  iShares S&P 100 . In that sense, this new Vanguard fund, which launched a few weeks ago, flatters by imitation. Like those other ETFs, it also owns many of the market's biggest, most-dominant names, with wide-moat stocks accounting for roughly 55% of its assets. But it stands apart from those funds in an important respect: Its holdings are cheaper, as the portfolio was recently trading at a hefty 15% discount to what it's worth, in our view. And it wouldn't be a Vanguard fund if it wasn't dirt cheap: It levies a paltry 0.13% expense ratio.

Claymore/Great Companies Large-Cap Growth 
Because we recently profiled this fund in our "ETFs on Our Buy List" article, we'll keep it short: The fund is chock-full of cheap, high-quality financial- and consumer-related names. It was recently trading at a 12% discount to our fair value estimate, which handily exceeds the 9% discount that we'd ordinarily demand from a diversified ETF like this one. It's not the most inexpensive diversified large-growth ETF money can buy, as its 0.60% expense ratio is on the high side. But even after factoring in that price tag, we'd still expect the fund to return roughly 15% per annum in the coming three years.

WisdomTree Low P/E 
This fund's index compiles stocks that have posted positive cumulative earnings in the last four quarters, ranks them by price/earnings (P/E) ratio, and then whittles the list down to the cheapest 30% of the bunch (i.e., stocks sporting the lowest P/E ratios). Rather than weight those remaining stocks by market cap or P/E ratio, the index weights them based on the aggregate dollar value of earnings each churned out in the previous four quarters, with the most-profitable businesses getting top billing, and vice versa. The upshot? The index has homed in on values in many of the same places we're finding them, notably the financial services and consumer-related sectors, which have gotten crushed in recent months amid fears over a widespread credit crunch. It was recently trading at a 14% discount to our fair value estimate, which puts it squarely in "bargain" territory.

First Trust Large Cap Value Opportunities AlphaDEX 
We're not wild about this fund's 0.70% expense ratio, which is among the highest of any large-value ETF. And we're not yet sold on its quasi-active approach, which compares and ranks stocks in the S&P 500 Index based on various growth and value metrics. But the fact is--the portfolio is chock-full of bargains. Of the 170 portfolio holdings that our analysts cover, nearly 100 were recently trading at a 10% or greater discount to fair value. Not surprisingly, the bulk of those names are nicked financials and consumer-related names such as card merchant  Discover Financial Services  or retailer  Sears Holding . The portfolio is widely diversified, so we wouldn't need a wide margin of safety to own the shares, which were recently trading at a 17% discount to our fair value estimate.

Portfolio Building Blocks

 Vanguard FTSE All-World ex-U.S. 
This ETF puts the whole world in your hands. Well, almost--it excludes U.S. stocks. But pretty much everything else is in there, as the portfolio traverses both developed- and emerging-market countries and spans firms of all shapes and sizes. One-stop diversification of this kind is itself fairly unusual, as most foreign index funds limit their scope, with many tracking MSCI EAFE, a commonly cited proxy for firms in developed nations. As such, this fund is uniquely suited to those investors seeking a one-stop option to complement a U.S.-centric portfolio. But what really sets this ETF apart is its cost: 0.25% of assets, which makes it one of the cheapest diversified foreign funds around.

SPDR S&P International Small Cap  and iShares MSCI EAFE Small Cap 
Foreign small-caps have been one of the hottest parts of the market in recent years. Investors certainly seem to have taken notice: Many of the better foreign small-cap mutual funds have closed after receiving heavy asset inflows. Consequently, it can be difficult to find a worthwhile foreign small-cap fund that's still open to new investment. These offerings make that task a bit easier, as each trawls developed countries for small-cap stocks. We'd of course caution investors considering the funds based solely on foreign small caps' strong recent returns. But if it's diversification you seek, these funds are worth considering, although we'd probably give the nod to the iShares fund, whose 0.40% expense ratio is 20 basis points cheaper than the SPDR offering's.

IShares S&P World ex-U.S. Property 
This was one of three foreign real estate ETFs that launched in 2007. (SPDR Dow Jones Wilshire International Real Estate , the first such ETF, made its debut in 2006.) ETFs like these, which target real estate owners and operators the world over, can come in handy if you're seeking to further diversify your portfolio's real estate stake, especially if you already own a U.S.-centric real estate fund. Although there are a few differences at the margins among the current crop of foreign real estate ETFs, they're pretty similar on the whole. That argues for going with the cheapest of the bunch, a distinction that currently belongs to the iShares fund, which carries a modest 0.48% price tag. That said, given how narrowly targeted the fund is, we wouldn't jump whole hog into it, and it goes without saying that it's appropriate only for those with suitably long investment horizons.

Vanguard Total Bond Market ETF 
True, this ETF doesn't break new ground: It mimics the Lehman U.S. Aggregate Bond Index, a benchmark that  iShares Lehman Aggregate  has been tracking ever since its September 2003 launch. But it represents an advance in a few respects. First, the Vanguard fund's 0.11% expense ratio is roughly half the iShares offering's, making it the undisputed cost king. That's a key advantage given that expenses loom large in the absolute-return-constrained bond world. Second, the Vanguard fund's portfolio consists of 3,000-plus bonds, far more than the 160 or so securities that the iShares ETF holds. That difference is noteworthy when you consider that the Lehman Aggregate index spans more than 9,200 bonds, meaning that the iShares offering owns a very small percentage of the index. Although the iShares fund hasn't had trouble tracking the benchmark, its concentrated portfolio courts a higher risk of tracking error. We expect that to be less of an issue with the Vanguard fund.

iShares S&P National Municipal 
With the launch of this fund, ETFs crossed a new frontier into the municipal-bond world. The jury is still out on how well the fund will track its index, however. For instance, to address the muni market's notorious inefficiency, this fund's benchmark, the S&P National Municipal Index, excludes bonds that are part of small issuances (less than $50 million par value). In addition, the portfolio will hold only a fraction of the 3,000-plus securities that make up the index. Although those measures should ensure that there's ample liquidity in whatever bonds the fund is holding, they also increase the risk of tracking error. Nevertheless, we think this fund's launch marks a welcome development. In addition to the many actively managed options that already exist, investors will no doubt benefit from having cheap, passively managed offerings like this one to choose from. To be sure, SPDR Lehman Municipal Bond  is cheaper than this offering. However, we're not enamored with that fund's quirky creation/redemption mechanism, which could cause that ETF's price to diverge from net asset value.

 

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Jeffrey Ptak, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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