By Robert Goldsborough
One nice thing for investors about exchange-traded funds is that they come in so many different sizes. Some are incredibly diversified, holding hundreds--if not thousands--of stocks, while others offer very concentrated exposure to a given sector or geographic region.
The quirky suite of equity sector-themed HOLDRS funds, issued by a Bank of America Merrill Lynch subsidiary, falls into the latter category. And right now, three HOLDRS ETFs (in technology, pharmaceuticals, and banking) are trading well below their portfolios' respective price/fair value valuations, as calculated by our equity analyst staff, and represent compelling opportunities for investors.
First, a quick primer on HOLDRS: While HOLDRS funds trade on an exchange, they do not-- unlike other ETFs--track indexes, and they do not add new holdings. Instead, they reflect whatever selections Merrill made at the funds' inceptions in 2000, with deletions taking place only as a result of corporate events such as mergers, acquisitions, and de-listings. Because Merrill doesn't reconstitute or otherwise tinker with its portfolios, the holdings coast along with the market.
These unusual rules have led to some strange current-day HOLDRS. Easily the oddest one (and the one that takes concentration to the extreme) is B2B Internet HOLDRS (NYSE:BHH), an Internet-themed fund that once held close to 20 names and was aimed at tracking the "B2B" (business-to-business) trend that was so common more than a decade ago. So many of the fund's original holdings--such as Commerce One, Agile Software, CheckFree, QRS, and Verticalnet--have been acquired by other firms or gone bankrupt that today BHH contains just two holdings: Ariba (NASDAQ:ARBA), which makes up a whopping 92% of the fund (and which Morningstar does not cover), and Internet Capital Group (ICGE). Effectively, B2B Internet HOLDRS is an investment in Ariba.
Meanwhile, other HOLDRS are dominated by just one or two firms. For instance, Telecom HOLDRS (NYSEARCA:TTH) has more than 80% of its assets invested in just two firms: AT&T (NYSE:T) and Verizon (NYSE:VZ). Biotech HOLDRS (NYSEARCA:BBH) has 35% of its assets invested in Amgen (NASDAQ:AMGN), 26% in Biogen (NASDAQ:BIIB), and another 24% in Gilead Sciences (NASDAQ:GILD).
Having said all that, we find most other HOLDRS generally to be good proxies for the respective industries that they cover. In addition, from a fee standpoint, HOLDRS portfolios require investors to make their purchases in round 100-share lots, with annual custody fees of $0.08 per HOLDRS share. Merrill waives these custody fees if the underlying securities fail to generate enough in dividends or cash distributions to cover the fees. For example, if a HOLDRS fund were trading at $50 per unit, investors would have to purchase 100 units for $5,000 and pay just $8 in total annual fees, which equates to a very cheap expense ratio of about 0.02%.
Right now, Morningstar's equity analysts' valuations of HOLDRS funds' underlying holdings reveal three HOLDRS funds to be incredibly inexpensive relative to the entire ETF universe. In fact, our ETF screener shows that these three funds are among the 10 least expensive U.S. ETFs on a price to fair value basis, among all ETFs with a sufficient number of holdings covered by Morningstar's equity analysts. What's more, Morningstar's equity analysts generally have assigned "low (or at most, "medium") fair value uncertainty ratings to the stocks held in these three HOLDRS, suggesting that investors interested in these specific sectors can use these funds to get exposure to these sectors with fairly low risk, on top of the reasonable valuations and low fees. It's probably not surprising that the three funds in question are dominated by large-cap names and have fairly minimal small-cap exposure, since Morningstar's equity analysts generally find large-cap stocks to be cheaper than mid- and small-cap right now.
The three funds that we believe are especially undervalued follow:
Regional Bank HOLDRS (NYSEARCA:RKH)
One important thing to highlight about this fund is its misleading label. Despite what its name would imply, the majority of this ETF's assets are invested in larger banking institutions that don't qualify any longer as regional banks. However, Regional Bank HOLDRS is a great way to get concentrated exposure to large national money-center banks, which Morningstar's analysts believe are significantly undervalued. The fund's top-three holdings-- JP Morgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), and U.S. Bancorp (NYSE:USB)--together soak up more than 60% of assets. At the same time, with the financial crisis in the rearview mirror, the national and superregional banks steering the performance of this ETF have their fingers in just about every financial-services business under the sun: We believe that these diverse businesses give the larger banks an advantage over smaller rivals relying on just the traditional banking model. As such, we believe that large money-center banks are on the cusp of finally generating the levels of revenues that they haven't been able to up to now. Plus, because Morningstar's equity analysts consider all three of the fund's top holdings to be significantly undervalued, investors should find RKH's current valuation--79% of fair value--to be compelling. In fact, RKH is the second-cheapest exchange-traded product with sufficient coverage by Morningstar's analysts.
Internet Architecture HOLDRS (NYSE:IAH)
Given that HOLDRS funds came out in 2000, it is probably not surprising that so many focused on the Internet. In addition to the B2B Internet HOLDRS fund that we mentioned above, there are a wide variety of HOLDRS geared toward the Internet: Internet HOLDRS (NYSE:HHH)--which has major positions in Amazon.com (NASDAQ:AMZN), eBay (NASDAQ:EBAY), and Yahoo (NASDAQ:YHOO)--Internet Infrastructure HOLDRS (NYSE:IIH)--whose largest holdings by far are VeriSign (NASDAQ:VRSN) and Akamai Technologies (NASDAQ:AKAM)--and Broadband HOLDRS (NYSE:BDH)--which devotes 59% of its assets to Qualcomm (NASDAQ:QCOM). However, the fund that we find both compelling and undervalued is Internet Architecture HOLDRS that is a concentrated way to play three companies--which make up about 76% of assets--through one trade. The fund has 14 holdings in total but is very top-heavy, with about 37% of assets invested in IBM, 24% devoted to Apple (NASDAQ:AAPL), and 15% invested in Hewlett-Packard (NYSE:HPQ). Morningstar's equity analysts find Apple and Hewlett-Packard both to be significantly undervalued and IBM to be fairly valued. As a result, a position in this ETF, in our minds, is a concentrated bet on high-quality technology and in particular, a bet on Apple, Hewlett-Packard, and IBM. And given that this ETF trades at an attractive 85% of fair value, we think it offers a compelling margin of safety for investors interested in tech.
Pharmaceutical HOLDRS (NYSEARCA:PPH)
Also an inexpensive ETF trading at 85% of fair value, this fund owns a large number of "big pharma" names. It has just 15 holdings, but the fund effectively is a bet on four stocks that comprise more than 70% of the fund's assets: Johnson & Johnson (NYSE:JNJ) (which itself makes up more than 24% of PPH), Pfizer (NYSE:PFE), Merck (NYSE:MRK), and Abbott Laboratories (NYSE:ABT). Why do Morningstar's equity analysts find big pharma names so inexpensive right now? Clearly, investors have been spooked by patent losses, increased competition, pipelines of late-stage drugs with poor chances of approval, and even product recalls, along with questions about growth that big pharma firms have been trying to answer in large part through external growth. We see Pharmaceutical HOLDRS as a way to give investors more diversification than owning any single one of these names while, at the same time, enjoying the benefits from holding a concentrated basket of pharmaceutical names that is dominated by the industry's big-four titans--all of which Morningstar's equity analysts believe are significantly undervalued.
Given that all three of these funds offer very little in terms of diversification, we'd urge would-be investors to treat these funds as investments to be implemented tactically as small satellite holdings. And, of course, in all of these spaces, investors have other ETF options. However, all such options carry higher fees, are less concentrated, and are less undervalued than the HOLDRS funds we highlight here.
We should note some final points about HOLDRS funds. HOLDRS are organized as grantor trusts, which exempt them from certain diversification standards that are required of open-end mutual funds. They also give investors undivided beneficial ownership in the stocks that they hold, meaning that HOLDRS owners can directly receive the dividends and disclosure documents (like proxies and annual and quarterly reports of each stock in the basket) as if they had owned each company individually. As such, investors have the right to take direct control of the shares of the underlying stocks any time they want. And because HOLDRS are static, there rarely are any capital gains distributions. This gives investors a lot of control over when capital gains are realized. This is because when investors cancel their HOLDRS fund, they pay a fee but don't realize any capital gains because the transaction is essentially an in-kind exchange of shares. Once investors own the underlying stocks, investors can sell the losers to offset current and future gains of the winners.
In the end, HOLDRS charge very low fees and can make great investments for investors who have a strong conviction about a specific group of stocks. As we note earlier, the above funds look very inexpensively valued and could make appropriate tactical satellite investments.
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.