Morningstar Advisor - August/September 2011 - 69

return an investor requires for taking on the risk
of owning the stock.)
Momentum investing is a strategy of buying
investments that have had strong returns
over the past six to 12 months, and it's based
on the idea that markets aren't random
and trends exist. Research has shown that
momentum generates outperformance in
almost every market and asset class tested.
Momentum's profitability seems to contradict
the fact that many retail-level performancechasers
underperform the market. There is no
contradiction. They lose out because they
hold on to hot investments for far too long,
riding collapsing trends down.
And Total Return 12 Mo . 28.0%
By looking for an average stock rating greater
than 3.3, we're going to find the areas of
the market that Morningstar equity analysts
think are most undervalued. Then, looking
at ETFs with one-year returns greater than 28%
will take advantage of momentum trends.
By combining a value metric and a momentum
metric, our goal is to find undervalued
securities with good momentum. The screen,
performed in Morningstar Principia and run
in mid-July, came up with 54 results out of 517
U.S.-equity ETFs. On a sector basis, there
are five health-care, four large-value, four
large-blend, three large-growth, one energy,
two technology, and one natural-resources
offerings in the results. Here are four of the
resulting ETFs that could make sense in the
current environment.
iShares Dow Jones US Pharmaceuticals IHE
This ETF offers investors exposure to a
high-quality portfolio of domestic pharmaceutical
companies. Given the health-care sector's
lack of sensitivity to the overall economic
climate, investors may consider this fund as a
defensive tilt for their portfolios. The healthcare
sector has hit a lull in recent years, as key
blockbuster drugs have lost exclusivity and
a blitz of competition ensued from generic drug
firms. The overhang weighing on large
pharmaceutical firms has partly dissipated,
with investor focus having returned to
industry-specific, nonregulatory issues that
drive pharmaceutical profitability. The secular
growth story is incredibly appealing, given
that the United States is home to approximately
78 million baby boomers who will presumably
require increased levels of medical
treatment and care going forward. Studies
have shown that the majority of the average
person's total medical costs over his or her
lifetime are spent in the last few years of life.
iShares Dow Jones US Oil Equip. Index IEO
Unlike vertically integrated oil companies
such as ExxonMobil XOM and Chevron CVX, the
companies held by this fund are primarily
focused on the exploration and production
of oil and natural gas. This gives the fund more
exposure to price changes in oil and gas and
less revenue diversification than those of other
oil- and gas-themed funds that hold large
integrated energy companies. The top 10
holdings of this ETF are all constituents of the
S&P 500, and represent 60% of fund assets.
Exploration and production is a risky and highly
capital-intensive industry in which fortunes
are largely determined by volatile crude oil and
natural gas prices. An investment in IEO
should be made with the expectation that oil
prices will stay elevated and will continue
to rise in the future.
Market Vectors Steel SLX
With its narrow industry focus, investors
should treat SLX as a tactical satellite
investment to complement a broadly diversified
portfolio. In terms of overlap with the standard
core holdings, there isn't much. Only four
stocks from Market Vectors Steel are in the
S&P 500 as well as having only four different
common holdings with the MSCI World Index.
The low correlation and overlap with core
indexes provides significant diversification
power to a standard portfolio. SLX also could
be a good fit for investors with a negative
outlook or wanting to hedge against dollar
exposure, given that nearly 60% of the fund's
assets are invested in international companies,
and given that steel by nature is a commodity
whose price generally moves in a direction
inverse to the dollar.
Over the longer term, Morningstar's equity
analysts believe that captive raw materials and
efficient operations are among the keys to
solid profits in steelmaking, with vertical
integration less important and input prices now
displaying greater volatility than in the past.
Given the volatility of this index over the past
few years, any investor looking to buy this ETF
should be prepared for a bumpy ride.
Vanguard Information Technology VGT
VGT holds mostly large, well-established
technology firms-the average market
capitalization of the fund's holdings is around
$41 billion-so investors who want exposure
to more-speculative small- and mid-cap
tech firms should look elsewhere. Although
VGT holds a large number of stocks (418), it's
nonetheless very top-heavy; its 10 largest
holdings account for a significant 52% of the
portfolio. VGT also has a very high-quality
portfolio--wide-moat and narrow-moat firms
account for about 46% and 35% of the
portfolio, respectively, meaning that Morningstar's
equity analysts believe that more
than 80% of the firms that VGT holds have
sustainable competitive advantages.
In this current technology environment,
investors are focused on a number of trends
that are expected to drive earnings in the
near term. In our view, an overwhelming
majority of companies included in this ETF have
displayed resiliency and should continue to be
nimble enough to succeed in the face of
rapid innovation, short product cycles, and
unpredictable consumer and corporate
spending-issues that drive volatility in the
tech sector. Still, we'd stress the importance of
monitoring valuation when investing in the
intensely competitive, maturing tech sector.
Timothy Strauts is an ETF analyst with Morningstar.
MorningstarAdvisor.com 69
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