Five ETFs to Let Run

| About: iShares MSCI (EFA)

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.

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 (NYSEARCA: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 (NYSEARCA: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 (NYSEARCA: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 (NYSE:XOM) and Chevron (NYSE: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 (NYSE: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 (NASDAQ: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 (NYSE:JNJ) or Pfizers (NYSE: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.

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