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By Robert Goldsborough

Exchange-traded funds are great complements to or substitutes for mutual funds, but they are also effective vehicles for speculating on secular trends in the equity markets. Morningstar's ETF Screener can be a great place for investors to hunt for ETFs that are undervalued. Because Morningstar has nearly 80 equity analysts following and valuing about 1,600 stocks that trade in the United States, we are able to value many ETFs when our analysts cover a sufficient number of ETFs’ underlying holdings. Morningstar’s equity analysts compute their estimates of intrinsic values of all of the companies that they cover, and then we aggregate and weight those values to calculate the fair value of an equity ETF. Equity sector and thematic ETFs’ price/fair-value discount can be a good measure for investors looking to locate an undervalued ETF.

Right now, Morningstar's ETF Screener shows that one of the most attractively priced funds for which we have an estimate of fair value is Market Vectors Steel ETF (NYSEARCA:SLX), which is the largest ETF geared toward the steel industry. At a price/fair value of 83%, SLX trades at the deepest discount of any equity sector ETF outside of the distressed financial sector.

Are steel-oriented ETFs a compelling place for investors to be right now? Let's take a closer look first at what is going on in the global steel industry, and next, which ETFs investors might consider to gain steel-industry exposure.

Volatile and Highly Cyclical, but Buoyed by Emerging-Markets Growth
Steel is a key input in a wide range of industries that depend heavily on economic growth, including commercial and residential construction, appliances, automobiles, and a wide range of infrastructure, including roads, bridges, and railroads. As such, demand for the commodity has been highly cyclical over the years, and steel prices have been badly beaten up during the most recent downturn.

In addition, for steel prices, the economic recovery has been choppier than anyone expected. Steel producers have had to deal with myriad issues, including higher raw materials costs (specifically, key production input iron ore, which has moved from annual and subsequently quarterly pricing to far more volatile monthly pricing), fragmented competition, and increasingly more variable capacity (steel makers are far more willing to adjust production levels now than they were in the past).

At the same time, although supply now plays a much greater role in determining steel prices than it once did, there's no question that longer-term, demand from emerging-markets countries and a lack of imminent new production capacity of iron ore should generally help to support steel prices. Even after further global production capacity now under construction comes online over the next few years, continued emerging-markets demand should help to keep prices high. In fact, fully half of the world's steel consumption is in China.

Why is the steel-making industry so out of favor right now, relative to other industries? Morningstar's equity analysts believe that the reason can be summed up in one word: uncertainty. The steel sector always faces a certain amount of cyclicality--Market Vectors Steel's beta compared with the S&P 500 is around 1.42, meaning that all else equal, the fund would be expected to perform 42% better than the benchmark in an up market and 42% worse in a down market.

Our analysts believe that given significant recent volatility in the steel industry, the equity markets currently see steel producers as a "show-me" story, and are not giving players credit for projected volume growth and higher selling prices--and ultimately, higher profit margins--over the next several years. Looking at the global market, we believe that the sector will recover in conjunction with economic growth both in developed markets and in emerging markets.

ETFs Focused on the Steel Industry
Currently, there are three ETFs that we feel are the best options for investors interested in investing in the steel industry. We highlight each one below, along with some comments. But first, a caveat: It's important for investors to understand the difference between steel makers themselves, which have been hit hard in recent years because of higher raw materials costs, and iron-ore miners, which had record profits during the downturn by virtue of selling higher-priced raw materials. Firms like ArcelorMittal (NYSE:MT) and Nucor NUE are steel makers, while companies like Vale (NYSE:VALE), Cliffs Natural Resources (NYSE:CLF), BHP Billiton (NYSE:BHP), and Rio Tinto (NYSE:RIO) are iron ore miners.

Complicating matters in steel-industry ETFs is that these funds hold both kinds of companies. Iron-ore miners tend to be larger companies based on market capitalization, and both of the steel-only ETFs are market-cap-weighted funds. As a result, several of the largest holdings in each fund are iron-ore miners, but ultimately, the vast majority of the holdings in each ETF are steel makers, and not miners.

Market Vectors Steel (SLX) (0.55% expense ratio)
Launched in 2006, this is the biggest--and least expensive--pure-play steel ETF. With just 26 stocks, SLX is a concentrated way to invest in the industry, and it holds companies from around the globe. In fact, because the industry's largest players are domiciled abroad, nearly 64% of this fund's assets are invested in international companies, although all of the holdings in this fund are listed in New York, including foreign steel makers such as ArcelorMittal and POSCO (NYSE:PKX) and foreign iron ore miners such as Vale and Rio Tinto. The foreign exposure makes this ETF a good fit for investors wanting to hedge against dollar exposure (steel prices generally move inverse of the dollar). This fund also is relatively liquid, trading close to 150,000 shares a day. We would note that the world's largest mining company, BHP Billiton, is not held in SLX.

PowerShares Global Steel (NASDAQ:PSTL) (0.75% expense ratio)
This is the only other pure-play steel ETF on the market. PSTL holds 62 companies, and therefore is much more diversified than SLX is. In addition, its holdings almost entirely are based overseas; U.S. companies make up just 11% of this ETF's assets. Major foreign steel making holdings include VALE, ArcelorMittal, Posco, ThyssenKrupp, Novolipetsk Steel, and Nippon Steel, while U.S. steel makers held here include Nucor, Allegheny Technologies ATI, and U.S. Steel (NYSE:X). Among global miners held in this ETF are VALE and Cliffs Natural Resources.

Morningstar's equity analysts do not cover enough of the companies held in this fund for us to have an estimate of fair value for this ETF, although we would generally expect it to be as inexpensive as Market Vectors Steel ETF is. Like SLX, PSTL is market-cap-weighted, meaning that its holdings tilt toward the largest publicly traded steel companies. And since PSTL was rolled out in 2008, its performance has been 95% correlated with that of SLX.

We highlight two issues with this fund, however. First, with less than $6 million in assets and an average of less than 4,500 shares traded each day, this is an incredibly thinly traded fund. Investors should buy and sell this fund only with limit orders; in addition, they should watch bid-ask spreads closely. Second, given this fund's high level of correlation in performance with SLX and its meaningfully higher price tag, investors probably are better off going with SLX. PSTL probably makes the most sense for investors looking for a basket of foreign-listed steel makers all in one trade.

SPDR S&P Metals & Mining (NYSEARCA:XME) (0.35%)
A good alternative that goes beyond steel, this ETF holds only U.S.-based firms and has 41 holdings, which fall into a variety of subsectors. Steel firms make up 30% of XME's assets, while diversified metals and mining companies comprise another 23% of the fund and coal companies make up another 21% of assets. XME even has small allocations to gold-oriented companies (12%), precious metals and minerals firms (8%), and aluminum companies (7%). Morningstar's equity analysts do not cover enough of this fund's holdings for us to calculate a fair value. We also would highlight that XME's underlying index follows an equal-weighting scheme, giving this fund more of a small- and mid-cap tilt. As a result, in this fund, mega-cap mining companies like copper miner Freeport-McMoRan Copper & Gold (NYSE:FCX) sit shoulder-to-shoulder with pint-sized miners like US Gold (NYSE:UXG).

No matter which ETF an investor considers in order to gain steel-industry exposure, we would emphasize that given their narrow exposure, these ETFs should be treated as tactical satellite investments that complement a broadly diversified portfolio.

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: Steel ETFs: Investing in an Out-of-Favor Sector