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If you're interested in investing in exchange-traded funds, you won't want for choices: As of midyear, there were 281 exchange-traded funds in the U.S., with approximately $350 billion in assets. Of these, international and sector funds drew the biggest asset inflows: $27 billion year to date.
However, all of these choices doesn't make it any easier to choose. And that's where we come in.
What top five ETFs does our model currently like?
Before we start, a few caveats about our approach. The ETF ratings model is momentum-driven. At the start of a bullish trend, it will detect performance changes and weigh these against past performance and volatility. In addition to pricing and returns, it will rank a fund on expense efficiency and downside risk. The net result is a mechanical trading process that can be applied systematically and easily -- week after week -- to derive trading ideas and review trends.
That's the good news.
Unfortunately, past performance is not a guarantee of future results. The exchange-traded funds industry is morphing from simple, passive, index-based baskets into new forms of actively managed funds. Although we rate a total of more than 16,000 funds, including stocks, bonds, closed-end and exchange-traded funds, we do not currently rate all funds and probably never will.
Some funds are too new or specialized to be of general interest or useful. Also, the secret of our system is that it is a quantitative approach that removes the speculation and human emotion that typically influences buy and sell decisions.
But computers can occasionally be wrong. Use this list as a guide for your own homework and discussions with others.
Here's the list, and then some of the things you should keep an eye on when investing in ETFs.
It's no surprise that first on the list is the
iShares S&P Global Energy
(IXC) exchange-traded fund.
This ETF combines the natural resources investment theme with the globalization trend. It holds 50% of its portfolio in non-U.S. stocks, giving some partial diversification away from the U.S. dollar. IXC concentrates on the largest global natural resources companies. Its top 10 names, which include
, represent 62% of this 68-stock portfolio. IXC is a nice double play on energy and global stocks, with a year-to-date return of about 18%.
Next on the list is the
iShares Russell Mid Cap Value
(IWS) exchange-traded fund. The idea with this type of fund is to find stocks that are undervalued with lower price-to-book ratios. In times of slowing overall growth, these become relatively more attractive.
But individual value stocks may remain undervalued by the market for a long time. For example, the fund's largest investment,
Archer Daniels Midland
is usually the first stock mentioned today when discussing ethanol, but before last year ADM lagged the market performance.
Fortunately, IWS includes more than 500 U.S. stocks and is broadly diversified. Its largest concentration -- about a third of its overall portfolio -- is in financial services, which normally sell based on book values and are interest rate-sensitive. IWS, with a modest 1.65% yield, is a defensive way to position your investments for a slowing economy and a halt in Fed interest rate increases.
Our model also likes the
Select Sector SPDR -- Energy
(XLE) exchange-traded fund. This index fund of 32 U.S. stocks is for those who want a concentration of energy names but do not want to spend the time researching, picking and tracking individual stocks. The top names in the fund include Exxon Mobil,
Like all sector funds, this narrow focus tends to produce more volatile up-and-down price movements than funds that diversify across many sectors and companies. Despite this volatility, XLE is a favorite of active traders because of its high liquidity and low expense ratio. The increases in natural gas prices over the past few days have added further fuel to this already hot sector fund.
Location matters. Two of our top 5 ETF picks point to Europe.
The most liquid of these is
iShares S&P Europe 350
(IEV). This international exchange-traded index fund mirrors European stocks that have depositary receipts trading on U.S. exchanges, currently around 358 stocks. The fund is characterized by a strong 30% of its portfolio in European financials and significant individual positions in global pharmaceutical stocks such as
and Roche (RHHBY). Overall year-to-date returns are around 15%-16%. Over the prior three years, price-based returns have averaged 23%, a very respectable historical return from a broad range of leading companies.
Finally, our model also suggests taking a closer look at utilities funds. The most liquid way to do this is via the
Select Sector SPDR-Utilities
(XLU) index fund. Normally sector funds tend to be more volatile than funds that diversify across many sectors and companies, but in contrast XLU has been very stable. The fund's 3.2% yield and relatively high payout of 55% to 60% of earnings as dividends compensate for the slow 7% forecasted earnings growth for the 32 stocks in the index. The results have been favorable. XLU posted returns of 10% year to date and 17% for the prior three-years. In a downward trending or slowing economy investors will put greater relative value on solid performance and cash flows
What were the keys to better future results?
Year to date the difference in performance between the best-performingsector fund -- Select Sector Energy (XLE) up 16% -- and the worst performingone -- Select Sector Technology (XLK) down 5% -- was a surprising 21 percentage points.
Average capitalization was less important than style. Value funds have generally been doing well, regardless of average size. Smaller size was only significant for growth stocks. But these were still important factors. Year to date the performance between the best-performing combined style-size indexes, using DJ Wilshire Indexes, was large-cap value up 8% vs. large-cap growth down 2%.
Again, location mattered. Go abroad. Our model has been pointing to non-US funds and ETFs for some time now as the best places to put new funds. There has been an explosion of international ETFs on European, Australian and Far East exchanges. The upcoming proposed merger of NYSE with Euronext could serve to further draw US institutional investors into these instruments and improve liquidity in these markets. The net effect could be greater investing transparency and results for the individual investor who is already familiar with currencies, ADRs and ETFs.
Rudy Martin is the director of research for TheStreet.com Ratings. While Martin cannot provide investment advice or recommendations, he appreciates your feedback;
to send him an email.