You are viewing an archive of a previous version of Click here to browse current articles or return to the main site.

Analyzing ETFs

The Team to Beat

Analyzing ETFs - March 7, 2007


The explosion of exchange-traded funds (ETFs) isn't just changing the way investors manage their money, but the way they evaluate funds.


Up until recently, ETF focused investment research was hard to come by, but not anymore.


A new wave of companies have targeted the emerging business of ETF data services and one such company has been quietly producing much needed research.


Michael Krause, the President of New York-based AltaVista Independent Research visits with us.


Q: What's the problem with ETF research from your perspective?


MK: Most of it is really warmed-over mutual fund research, which focuses primarily on past performance and fees. That’s a problem because it’s backwards looking, and because it has little if any predictive value for an ETF. Therefore the important question has to be, “What is the investment merit of that particular index?”


Q: There are so many ways to evaluate an ETF; there's the underlying stocks within the index, then too there's fees, also what about the fund company behind the product? Which of these factors are the most important?


MK:  If you were considering buying stock in General Electric—which after all is a collection of businesses not entirely unlike an ETF—then you would probably start by examining the fundamentals. This includes sales and margins, earnings growth, what’s happening on the balance sheet, etc., and how the stock was valued both against industry peers and versus the broader market.


Because ETFs are entirely transparent, unlike mutual funds, all those things can be known. It is possible to calculate expected earnings per share, earnings growth, and the P/E ratio, among other data points, from the underlying constituents. Using this information we can then make much more informed decisions—forward-looking decisions—about which ETFs make the most sense for our portfolios.


Q: The technology sector has been dead money over the past several years and the unfolding stock options scandal hasn't been a big confidence booster. What do you make of the backdating options probe?


MK: I’m in the minority on this one—and as a Value guy it’s a bit awkward defending Tech—but I see stock options as a non-issue.


In terms of stock option expensing, the market does not pay for changes in accounting rules. In 2002 the Financial Accounting Standards Board eliminated the amortization of goodwill, which like stock options is a non-cash expense. The move raised S&P 500 EPS by about $4.00, or 8%. Yet the market didn’t suddenly rally to cheer the newfound “earnings,” so I don’t see why the market should penalize tech stocks for the new “expense” which in no way affects the intrinsic value of a company.


As for backdating, I realize from a PR-standpoint the scandals don’t help things, but if you accept that executives are in a market position to demand a certain amount of pay, then it is in shareholders’ interest for that expense to be met in the most tax-efficient manner, and that means stock options. If companies were forced to give less in the form of stock options and more in straight salary, it would result in higher taxes—and that comes out of shareholder’s pockets too!


Q: What specific S&P industry sectors look good right now?


MK: I like the Financials (XLF) and Energy (XLE) Select Sector SPDRs. There could be a lot of upside to estimates for Financials, because the M&A boom is likely to roll on but the giant fees Wall Street receives from these transactions are not fully factored into to expectations yet.  As for Energy, although I have no crystal ball for oil prices the sector looks cheap based on average profitability through the cycle, not just the current boom earnings.


I would stay away from Consumer Discretionary (XLY), not because I am bearish on the U.S. consumer but because the current estimates for more than 10% earnings growth this year still appear too optimistic. Further, the sector trades at 19.2x those rosy figures, which is even more expensive than the Technology sector (XLK)! 


Q: What's your take on the sell-off in emerging market stocks?


MK: Overdone. To be sure, the iShares FTSE/Xinhua China 25 (FXI) fund is fairly expensive for a developing market, and remains so after the plunge, but not egregiously so. FXI now trades at 16.6x 2007E EPS, compared with 12.3x for the iShares MSCI Emerging Markets fund (EEM), and 15.1x for the S&P 500 SPDR (SPY).  


But note also that EEM was down 8.1% during the meltdown despite the fact that Chinese stocks make up only about 13% of assets, and even though the stocks which dominate the index are more exposed to the U.S. economy rather than the Chinese—implying, therefore, that last week's action might have been an over-reaction.


I am advising my clients not to abandon emerging markets, but if they must play China the better way to do it is through the iShares MSCI Taiwan fund (EWT), on the basis that FXI is in fact much more leveraged to China’s domestic economy, while the Taiwan fund is full of companies manufacturing in China for export, and hence are more leveraged to China’s emergence as the world’s factory floor.


Q: Thanks Michael.