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By Robert Goldsborough

For investors in most airline companies, 2010 has been a terrific year. Most air carriers' stock prices soared in 2010--a marked departure from the previous several years of pain from a weak economy, excess capacity, and oil price increases that in 2008 made fuel expenses their highest percentage of airline operating costs ever.

Driving this outperformance have been both fundamental and non-fundamental factors. The industry has emerged from the recession healthy, with passenger volumes rising nicely on effectively flat ticket prices and the carriers' non-fuel costs down or growing modestly at best. In addition, stock prices have been buffeted by a wave of consolidation that has begun taking place; Southwest Airlines (NYSE:LUV) recently announced that it will acquire fellow low-cost carrier AirTran Holdings (AAI), and United Airlines owner UAL Corporation recently merged with Continental Airlines to form United Continental Holdings (NYSE:UAL), the largest airline company in the world. These deals have come on the heels of Delta Air Lines (NYSE:DAL) acquiring Northwest Airlines in 2008, and they have helped underscore the fact that the entire airline industry seems to be embracing capacity discipline and is focusing on cost containment. In addition, investors ostensibly are pricing acquisition premiums into some of the remaining names in the space.

Explosive Stock-Price Returns
Holders of almost all airline companies have been rewarded nicely in 2010. United Continental, for instance, was up 125% in the first 10 months of 2010, while US Airways (LCC) rose 144%, Alaska Air Group (NYSE:ALK) increased 53%, and AirTran, buoyed by its purchase offer by Southwest, rose 42%. Other players also have registered nice gains, including JetBlue Airways (NASDAQ:JBLU) (up 28%), Delta (up 22%), Ryanair Holdings (NASDAQ:RYAAY) (up 22%), and Southwest (up 20%).

Traditional open-end mutual funds have modest exposure at best to the airline industry; for example, last month, Morningstar's Fund Spy column noted that no one mutual fund as of Oct. 7 had invested more than 14.5% of its assets in airlines. Instead, we believe that the best way to gain exposure to the entire airline industry while avoiding single-stock risk is through an exchange-traded fund. In addition, we highlight that the ETF structure offers some flexibility for investors that traditional mutual funds do not offer, including the ability to short an ETF that an investor believes is overvalued.

Investing in an Airline ETF
Right now, investors can consider just one airline ETF, the Guggenheim Airline ETF (NYSEARCA:FAA), which began trading in early 2009 and which has nearly doubled in price since that time. A concentrated ETF that holds just 23 airline companies, Guggenheim Airline is a modified equal-dollar-weighted fund, with large allocations devoted to United Continental (almost 19% of assets), and Delta and Southwest (each of which comprises another 15% or so of assets). Just over 75% of assets are invested in U.S. airlines; other U.S.-listed companies that FAA holds include US Airways, JetBlue, AMR Corporation (AMR), SkyWest (NASDAQ:SKYW), Alaska Air Group, and Ryanair Holdings.

Given current industry fundamentals and FAA's high valuation, we believe that this ETF would make a compelling short opportunity for an investor.

First, there is no question that investors in the airline industry need a strong stomach. There have been more than 180 bankruptcies in the industry over the past 30 years, and since deregulation in the late 1970s, the industry has been plagued by issues like capital intensity, minimal customer-switching costs, and cutthroat competition. In more recent years, oil-price volatility has only exacerbated the industry's structural issues. Indeed, famed investor Warren Buffett purchased preferred shares in US Airways (then known as USAir) in the early 1990s and later rode the company into bankruptcy before recovering and booking a small profit; Buffett has lamented that investment, calling it his worst one ever. He also has noted that in the airline industry, "you've got huge fixed costs, you've got strong labor unions and you've got commodity pricing. That is not a great recipe for success." And while, as we noted above, we are encouraged by better and more rational behavior on the part of the airlines in the form of capacity discipline and cost containment, the industry has to overcome a long track record to the contrary. On top of this, recently rising fuel costs have not yet begun to affect airlines' earnings results but undoubtedly will in coming quarters, quite possibly to a level greater than the carriers are suggesting in their guidance.

In addition, the valuation of air carriers is very high, in our opinion, and bound to revert to the mean, given that merger premiums appear to be baked into many companies' share prices. Although further consolidation unquestionably is ahead, we do not believe that all carriers will be acquired away, meaning that share prices are likely to fall back down to earth. Also, of the nine U.S-listed companies in this fund that Morningstar's equity analysts follow (comprising almost 69% of the assets of this ETF), just two--United Continental and AMR--trade at any meaningful discount to our analysts' fair value estimates. The other seven all trade at or above our analysts' fair value estimates. In addition, Morningstar's equity analysts assign uncertainty ratings of "very high" to five of these nine companies, and "extreme" uncertainty ratings to the other four: Delta, American, US Airways, and United. We believe those factors make an ETF that is ripe to be shorted.

FAA charges an annual expense ratio of 0.65%, which may seem high. However, this ETF holds airline stocks traded on exchanges all around the world, and it would be very costly for investors to try to assemble this same portfolio of companies on their own. We also would alert investors that this ETF is not very liquid, meaning that investors should keep a close eye on bid-ask spreads when transacting. That said, individual investors using limit orders for FAA probably won't run into any liquidity issues. And, we'd also note that taking an outright short position in a security, including an ETF, can expose investors to the unlimited loss potential if the ETF continues to rise. In addition, the expense ratio actually serves as a slight tailwind for the investor who is short.

Few Other ETF Options
Right now, FAA is the lone ETF with any meaningful exposure whatsoever to the airline industry. Other ETFs in which airline companies are included make fairly ineffective options for an investor who is searching for airline exposure. For example, five airline companies are included in the shipper-intense iShares Dow Jones Transportation Average (NYSEARCA:IYT) (0.47% expense ratio), which has the next-largest airline representation of any U.S. ETF. However, even in IYT, the air carriers have fairly small position sizes (together comprising less than 8.6% of the ETF's assets), and the performance of IYT and FAA hasn't been particularly correlated historically. After IYT, the representation by airline companies in U.S. ETFs drops precipitously. If anything, the best alternative is probably to buy single stocks of airlines, despite the risk that single-stock investing presents.

Note that ETF providers are known for chasing returns, with good-performing sectors typically having several product launches while they're hot. However, until recently, aviation has not had a prolonged period of strong returns while ETFs have been growing. So we would not be at all surprised to see other ETF providers launch niche aviation-themed ETFs in the future.

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.

Source: The Case for Shorting the Airline Industry via the Guggenheim Airline ETF