Best Ideas For 2011: Unlocking Morningstar’s ETF Portfolio

During an investor webinar Tuesday, Morningstar’s ETF team shared some of their best ideas for investing in ETFs in 2011 and provided a look inside their own portfolio. Overall, they recommended investors tilt their portfolios toward financial, technology and commodity ETFs.

At the end of last year, U.S. exchange-traded fund assets surpassed the $1 trillion mark for the first time. For investors, ETFs can offer an alternative to mutual funds with greater tax advantages and lower costs, said Paul Justice, director of ETF research at Morningstar. Unlike mutual funds, ETFs are traded on an exchange, giving access to just about anyone.

Mentioned In This Article

“ETFs have really been a growth story as we all know,” said Michael Rawson, ETF analyst at Morningstar.

Their first recommendation: invest in bank ETFs. Financials have sold off quite a bit, and Morningstar believes these stocks are in for a turnaround. While the S&P 500 has been relatively flat, the banking sector is still down about 50 percent.

“To some extent, there’s a little of a ‘Buy the Unloved’ here with banks,” Rawson said. “While it is not likely the banks will return to their historic levels of profitability, they still look relatively cheap or undervalued on a number of different metrics, such as price to fair value or price to earnings.”

In the recovery, financials haven’t kept pace with the broader market, Rawson said. In the next year, banks will continue to appreciate, and they’ll appreciate at a faster rate than the overall market. One sign is that lending activity has ticked up, and banks are pumping money back into the economy, rather than putting it into Treasury bonds, he added.

Rawson likes the SPDR KBW Bank ETF (KBE), because the fund is narrowly focused on large-cap banks. Most large-cap banks have already repaid their Troubled Asset Relief Program money, while some small-cap banks haven’t repaid yet.

In addition, each of the fund’s top four holdings--J.P. Morgan Chase, Citigroup, Bank of America and Wells Fargo—is undervalued on a price to fair value basis, he said. This fund is a better choice than a broader financial ETF, such as the Financial Select Sector SPDR (XLF), which includes insurance and real estate companies.

Technology

During the recession, earnings growth in the technology sector held up nicely, but these stocks were more expensive because of that growth. Now, however, technology ETFs might provide a good buying opportunity.

“Over the last two years, that premium has really shrunk so that tech stocks are only slightly more expensive than the rest of the market,” Rawson said. Their earnings growth is still better than the overall market. “We believe tech stocks offer growth at a reasonable price at this time.”

Two recommendations for getting tech exposure are the Technology Select Sector SPDR ETF (XLK) and the Vanguard Information Technology fund (VGT). Both funds have a high percentage in technology stocks and a higher percentage in wide moat stocks, or Morningstar’s definition of a competitive advantage firm.

Commodities
According to Justice, we are in a secular bull market for commodities, driven by the emergence of the consumer in Asia and the emerging markets. Long term, this should drive prices higher in such commodities as oil, base metals, and agricultural products.

While short term, commodities could see some volatility, the real demand factors are long term growth factors, including population growth and the modernization of the emerging markets. In addition, loose monetary policy continues to drive demand for commodities as an inflationary hedge in the developed markets, Justice said.

If he were going into commodities today, he would use the United States Commodity Index Fund (USCI), a new product.

“Why do I like it? This is a third-generation commodity fund. Now that sounds like a heck of a sales pitch for something with a lot of bells and whistles on it, but I really think the philosophy behind it is appropriate for people, and they shouldn’t be scared away from going into a fund that isn’t three years old or has a long track record here.”

It’s an index fund, so you know what it’s going after—commodities. The fund also looks to avoid the adverse effects caused by contango, he said. The fund invests in 14 of 27 eligible commodities on a monthly basis; the first seven are the most heavily backwardated contracts, while the remaining seven are those with the highest positive annual price change.