By now you're probably tired of predictions for 2007, so I'll spare you my thoughts on where the market is headed this year. However, in the course of conducting our research on exchange-traded funds, we've arrived at a few conclusions that are contrary to the prevailing wisdom.

Value continues to outperform growth. Value stocks have outperformed growth stocks for six consecutive years, about as long as growth predominated in the late 1990s. As a result, many strategists are forecasting an imminent reversal in fortune in favor of growth. But I believe that the excesses of the late 1990s were such that growth stocks are still relatively overvalued.

It's a dirty little secret, but the methodology used in selecting constituents for inclusion in the iShares S&P 500 Growth Index ( IVW) and iShares S&P 500 Value Index ( IVE) funds isn't particularly good at separating companies with fast earnings growth from those with slow earnings growth.

What it primarily seems to do is separate expensive stocks from cheap ones, on the apparent presumption that expensive ones are priced that way because they will deliver rapid earnings growth -- in a sense putting the cart before the horse. But since 2000, stocks in iShares S&P 500 Value have delivered faster compound earnings growth than the stocks in iShares S&P 500 Growth!

That's not to say growth stocks won't ever increase earnings faster than value stocks. In fact, this year companies in the iShares S&P 500 Growth Index are expected to grow earnings 10.6%, compared with growth of just 8.1% for companies in the iShares S&P 500 Value Index (although the value fund trounced the growth fund in 2006, with earnings growth of 18% and 11%, respectively).

But the point is that stocks in the growth index cannot be depended on to produce superior earnings growth over the long term. So it is unlikely that, in an environment of overall slowing in earnings growth, ( S&P 500 EPS growth is expected to slow to about 9% in 2007 from about 14% last year) where estimates are cut more often than they are raised, investors will be patient waiting for the ethereal promise of growth to materialize.


Value Trumps Growth
Compound annual growth rate in earnings per share from 2000 to 2006
Source: AltaVista Independent Research

The iShares S&P 500 Growth Index currently trades at about 16.4 times estimated 2007 EPS, compared with 13.9 times for the iShares S&P 500 Value Index. Remember, just because you "pay up" for earnings growth doesn't mean you'll get it.

With the exception of China, emerging markets continue to do well.. It's almost an article of faith on Wall Street that emerging markets are overdue for a fall. Citing the phenomenal performance of these markets over the past few years, and the fact that historically they have been very volatile, many strategists conclude that there must be a reversion to the mean, and therefore a nasty correction is coming.

Lucky readers who've doubled or tripled their money in emerging markets may want to take some profits to rebalance their portfolios, but we advise against abandoning the sector. The components of the iShares MSCI Emerging Markets Index ( EEM) still have a cheaper average P/E ratio than that of the constituents of the S&P 500, but it offers faster earnings growth.

I realize most would argue that emerging markets deserve a lower P/E ratio, but iShares MSCI Emerging Markets is composed of world-class competitors such as Samsung, many of which got to be that way by beating the pants off American (or Japanese) companies.

Further, the majority of stocks in this ETF are in the form of American depository receipts and thus are subject to the same accounting and disclosure requirements as, say, General Electric ( GE). We'd argue that Samsung's fortunes and the performance of its stock have more to do with worldwide demand for the company's products, and less to do with the fact that its headquarters are in Seoul.

One emerging-market fund we would avoid is iShares FTSE/Xinhua China 25 ( FXI), which is dominated by financial, telecom and energy firms, all of whose fortunes are tied to Chinese domestic demand.

While China's economy is growing at a blistering pace, iShares FTSE/Xinhua China 25 now trades at nearly 17 times estimated 2007 EPS, and expected 2007 growth for the fund is just 4%. That makes the fund more expensive and slower-growing than iShares MSCI Emerging Markets. It is also more risky, in our estimation, owing to its single-country focus and the lack of any internationally known companies in the fund.


Price-to-Earnings Ratio on 2007 EPS
Source: AltaVista Independent Research


Estimated 2007 Earnings Growth
Source: AltaVista Independent Research

Fundamental indexing proves its mettle. A lot of indexing gimmicks have been introduced over the past few years, but one innovation that has real value, in my opinion, is fundamental indexing. This strategy seeks to avoid the Achilles' heel of market-cap-weighted indices, which are by definition overweight stocks that later prove to be overvalued, and underweight stocks that later prove to be undervalued.

Although there are several approaches to fundamental indexing, I like the PowerShares FTSE RAFI 1000 ( PRF), which weights about 1,000 large- and mid-cap stocks according to sales, earnings, dividends and book value. Though the ETF has existed for just over a year, the back-testing results for fundamental indexing I've seen are impressive -- and not just for this single diversified product but sliced and diced across sectors, market-cap segments and geographic regions, in both bull and bear markets.

It's real-world results that matter, however. Compared with the iShares Russell 1000 ( IWB) fund, which has, by and large, the same constituents, but is purely market-cap weighted, the PowerShares FTSE RAFI 1000 outperformed by over 3.0 percentage points last year. The difference in performance is more than enough to compensate for the difference in expenses between the two funds (the PowerShares FTSE RAFI 1000 has an expense ratio of 0.60% while the iShares Russell 1000 charges 0.15%).


Fundamental Indexing Proves Its Mettle
PowerShares FTSE RAFI 1000 outperforms iShares Russell 1000
Note: Rebased, December 2005=100

I realize that one year of results is probably not enough to convince the skeptics, many of whom will maintain that it's too early to tell. But I believe the gap in performance between the PowerShares FTSE RAFI 1000 and the iShares Russell 1000 will continue to widen in 2007, proving the mettle of fundamental indexing. At any rate, I think the PowerShares FTSE RAFI 1000 could be an excellent choice for "set it and forget it" investors who seek to outperform the market over the long term by systematically avoiding market excesses.
Michael Krause is president and founder of AltaVista Independent Research. AltaVista provides fundamentally driven analysis of exchange-traded funds to help investors select ETFs based on investment merit, much the same way they would evaluate a single stock. The firm offers both print and online ETF research to subscribers, but does not manage clients' money. Mr. Krause is also a frequent contributor to broadcast and print media.

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