Four Promising Exchange-Traded Funds (ETFs)

	Paul Tracy Street Authority.com
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On March 21, 1924 three Boston businessmen pooled together $50,000 to form a company called the Massachusetts Investor's Trust. The purpose of the company: to invest in the roaring 1920s stock market boom.

These three men unwittingly gave birth to a financial revolution. In fact, in the ensuing 80 years their invention, the mutual fund, has come to dominate the retail investing landscape.

By 2004, U.S. mutual fund assets had grown from that $50,000 seed invested in a single fund into $7.4 trillion invested across 8,126 funds. Over 50 million American households now own mutual funds, making them by far the most popular and common means of participating in the stock market.

So with all that success, why then are mutual fund executives so nervous? After years of unfettered and unchallenged dominance of the retail investing landscape, there's a new kid on the block, a new asset class that threatens to challenge the mutual fund's pre-eminence.

And the mutual fund industry is vulnerable to that competition. One reason funds have become so popular is that they've been the only game in town for millions of Americans. Many retirement funds mandate investments into hand-selected funds. In addition, mutual funds have been, until recently, the easiest way to diversify a portfolio among a broad selection of different stocks.

Mutual funds have taken full advantage of this near monopoly. Fees charged for managing that $7 trillion pie have been creeping up. This has been true even since the advent of no-load funds in the 1970s. From 1990 to 2002, for example, the Investment Company Institute reports that the average mutual fund expense ratio jumped from 1.47% to 1.64%.

And most investors are keenly aware of several other drawbacks of traditional mutual funds. For one, they're only priced once per day so you can't buy and sell them as freely as you would a regular stock. In addition, most mutual funds also have minimum investment requirements, making them impractical for some investors.

A New Kind of Fund

So, what exactly is this revolutionary new investment that's challenging the mutual fund industry's dominance? It's called an exchange-traded fund (ETF). For those of you unfamiliar with ETFs, these unique financial instruments are essentially passive mutual funds -- similar to traditional index funds -- that allow investors to purchase a basket of securities in a single transaction. They're traded on the NYSE, AMEX and Nasdaq just like stocks.

Last year according to TrimTabs, nearly $55 billion flowed into U.S. ETFs. That's almost half of the $130 billion or so that flowed into U.S. equity mutual funds in 2003. Particularly amazing is how quickly this industry has grown. After all, the first ETFs hit the investment scene only a little over a decade ago.

ETFs address some of the problems inherent with mutual funds, but that's not the only reason we're so excited about this investment class. Instead, we've become more and more interested in ETFs in recent years because they are starting to open up an exciting new avenue of growth for U.S. investors, an avenue that until recently has been all but closed -- investing abroad.

Passport to Growth

The United States is the world's largest economy with an annual GDP in excess of $10.8 trillion. That's more than double the size of the world's second-largest economy, Japan, which weighs in at about $4.3 trillion. In addition, our nation remains a world leader in many important industries, such as finance and defense. By market capitalization, the U.S. stock market accounts for more than half of the value of all stocks in the world.

Although this enormous size and dominance has created some incredible opportunities for investors, it also gives us reason for caution. As the old saying goes, "Trees grow upwards but never reach the heavens." With this in mind, the U.S. economy, just by virtue of its enormous size, is unlikely to grow at an above-average clip in the coming decades. After all, the bigger a company or nation gets, the harder it becomes for it to post stellar growth.

Consider that if the U.S. economy were to grow by +10%, that would mean adding nearly $1.1 trillion to GDP. To give you some perspective on what that means, consider that $1.1 trillion is far more than the entire value of Spain's economy at $836 billion or that of Canada at around $834 billion. These are also staggeringly large figures when you consider that total world GDP is estimated at less that $37 trillion.

By contrast, China's economy is worth about $1.4 trillion. For China to grow by 10%, the nation would need to add just $140 billion to its annual GDP. To put that number in perspective, America's largest company, ExxonMobil, weighs in a little over $400 billion in market value.

Bottom line: The U.S. economy, while still the largest in the world, will not be able to match the growth of smaller, rapidly modernizing economies like India and China over the next few decades. In fact, China is already seeing double-digit expansion in GDP, and that growth is likely to continue for some time to come.

Until recently, it's been tough for U.S. investors to participate in this tremendous growth overseas. If you don't believe us, call your broker and try to buy a Chinese stock or even a stock from an industrialized country like Britain or Australia -- you'll find it a tough and expensive task indeed, even if your broker understands how to complete the trade.

Yes, you could buy a foreign mutual fund. Unfortunately, most don't offer specific exposure to a single, foreign market. What's worse, international funds tend to sport higher fees than domestic funds, making diversifying abroad a difficult and expensive task.

The good news for investors is that thanks to the introduction of dozens of foreign ETFs in recent years, ETFs have changed all of this. There are now ETFs that offer exposure to entire regions like Latin America and Europe. Meanwhile, other ETFs focus on single countries and markets such as Australia, Hong Kong and even China. And unlike foreign mutual funds, these foreign ETFs don't carry ridiculously high fees. For the first time, Americans have a chance to diversify their assets abroad and take full advantage of the tremendous growth the rest of the world has to offer.

The ETF Advantage

In addition to international diversification, ETFs boast several major advantages over mutual funds and common stocks. Here's a brief review:

Diversification -- Each ETF represents an interest in an underlying basket of common stocks. This allows investors to gain broad exposure to a large group of companies in one fell swoop. This diversification also makes ETFs much less volatile than common stocks.

Low Cost -- Unlike traditional mutual and index funds, you can purchase ETFs with no front- or back-end loads. In addition, because they are not actively managed, most ETFs charge minimal annual expenses of under 1%, making them much more affordable than most other diversified investment vehicles.

Liquidity -- Unlike traditional funds, ETFs can be bought and sold throughout the trading day, and many trade hundreds of thousands (and in some cases millions) of shares per day.

Dividends -- Many ETFs pass through the accumulated dividends paid by the stocks held in their basket. StreetTRACKS Wilshire REIT Fund (RWR), for example, pays a healthy 5% dividend.

Choices -- The American Stock Exchange alone lists well over 100 different ETFs. Some of these funds track broad U.S. equity market indices. Meanwhile, others track specific sectors or industry groups. Still others represent an interest in baskets of foreign stocks. And finally, others invest exclusively in the bond market. With so many options to choose from, you're certain to benefit from ETFs no matter what your investing/trading style.

Returns -- Many ETFs have done extremely well in comparison to the broader market over the past few years. As such, they deserve strong consideration for a place in your trading and investment considerations.

With all of these benefits in mind, nearly every investor could benefit by holding a position in one or more of today's leading ETFs. The main question is, which ETFs are worth your consideration? Below you'll find a comprehensive list of many of today's most popular U.S.-traded ETFs. In the analysis that follows, my staff and I will then bring you an in-depth look at four of our favorite funds.

EMERGING MARKETS ISHARES (EEM, $220.40)

Overview

The Emerging Markets iShares broadly tracks the performance of the Morgan Stanley Capital International (MSCI) Emerging Markets Index. This index represents the performance of the world's major emerging markets, including Korea, Russia, Taiwan and Brazil, among others.

Growth Drivers

As my staff and I explained above, in the coming decades emerging markets are likely to grow at a much faster clip than larger, more developed economies like the United States. This growth will be fueled by a number of different factors.

Asian economies, for example, are becoming important bases for global manufacturing operations. In China, major multinational companies are taking advantage of low labor costs to build factories. Meanwhile, domestic companies are making hefty sums by exporting goods to the West. That, in turn, is starting to boost Chinese income levels -- eventually this will lead to higher consumption and domestic consumer growth.

Meanwhile, in places like Latin America, growth is being driven partly by rising commodity prices. Rapid economic growth in Asia has led to high demand for basic materials like copper, lead and energy (oil and natural gas). Prices for these basic commodities are rising to levels unseen in two decades, and as a result, commodity-rich economies across Latin America stand to benefit.

Finally, many emerging markets are benefiting from credit expansion. Just think about the consumer growth witnessed in the U.S. after the introduction of credit cards and home mortgages. These products are in the early stages of multi-year growth curves in places like China and India. As such, we expect these nations to see years of strong growth in consumer spending power.

Valuation and Outlook

Despite the strong gains the fund has posted over the past few years, EEM's valuation is still quite compelling. Based on trailing 12-month earnings, EEM trades with an average P/E of just 11.2. That compares to an average P/E of around 17.9 for the S&P 500. This is despite the fact that several of the main countries represented in the EEM are growing twice as quickly as the U.S.

Emerging markets are certainly riskier than developed markets like the U.S. That means that we'd expect to see them trade at a slight valuation discount. But by diversifying among several countries in several different regions, these risks can be minimized. All in all, EEM looks like a solid long-term play on several fast-growing emerging markets.

ISHARES FTSE/XINHUA CHINA 25 INDEX FUND (FXI, $56.43)

Overview

The iShares China 25 Index Fund invests in 25 of the most liquid companies traded in China. That includes a broad basket of stocks in different industry groups; the three most important industries in FXI are financials, energy stocks and telecoms.

Growth Drivers

Some analysts have already dubbed the 21st century "China's Century." And for good reason. In fact, the nation's rapid economic modernization over the past decade has had major ramifications for the entire global economy.

Specifically, China has an almost unlimited labor force of around 1.2 billion people. Foreign companies have been investing heavily in manufacturing capacity in the nation in recent years. And domestic firms, sometimes aided by foreign investment, have also expanded rapidly. The result is a rising, growing middle class of Chinese consumers. Most analysts estimate the Chinese middle class to be over 300 million -- about the size of the entire U.S. population.

Granted, what passes for middle class in China isn't the same as in the U.S. However, as Chinese incomes rise, more consumers are demanding items like cars, modern electronics and the latest fashions from the West. China represents a vast pool of potential consumers for businesses around the world.

Apart from the consumer story, China is seeing booming foreign trade. After joining the World Trade Organization (WTO), the Chinese government pulled down tariffs and made it easier for foreign companies to invest directly in China. This sparked a massive boom in trade.

At first, most of China's exports headed to the U.S. However, more recently, Japan and other nearby Asian nations have become increasingly important markets for the nation. Growth in trade is yet another positive for this market.

Valuation and Outlook

You'd think that with the Chinese market growing at around a +10% annualized clip, Chinese stocks would be expensive. In fact, although China saw a tremendous run in 2003, the nation's stock market wasn't a good performer at all in 2004. In fact, it was one of the world's worst performing indices last year. The result: the Chinese market remains fairly cheap and the average P/E of the various holdings in FXI now stands at around 12.

Although the Chinese market is bound to see periodic setbacks, my staff and I believe that China is on a growth curve similar to Japan's in the 1970s and 1980s. As such, we expect to see rapidly rising incomes and consumer buying power in the years ahead. And while China is still much riskier than the U.S. market, the considerable valuation discount and superior growth make it an attractive investment option.

ISHARES MSCI AUSTRALIA INDEX (EWA, $18.04)

Overview

The Australia iShares invests exclusively in the Australian stock market. This fund is particularly focused on the energy and basic materials (commodity) industries. Taken together, companies in these two sectors account for about 36% percent of EWA.

Growth

Australia is blessed with a huge natural resource base. Even better, the country is located in Asia -- very close to many of the world's largest potential markets for those natural resources.

Perhaps the most important resource that the growing Chinese economy will need is energy -- coal, natural gas and oil. All of those new factories being constructed in China will require electricity to run. Meanwhile, cars are rapidly replacing bicycles on the streets of urban China -- all those cars are run with gasoline.

Between 1950 and 1990 Japan went from consuming 2 barrels of oil per capita annually to nearly 20. My staff and I expect China will experience a similar growth curve. Meanwhile, of course, the United States and Western Europe continue to import a great deal of oil to power their own economies. The result: rapidly rising energy prices.

Fortunately, Australia is particularly rich in coal, China's primary source of electric energy. The nation is already exporting more coal to China than any other country. Even better, Australia's coal is now being sold at record prices to neighboring China. In addition, Australia is also a producer of oil and natural gas -- two other important energy sources.

And outside the energy market, Australia is among the world's largest producers of copper, which is used for electrical wiring, as well as aluminum, which is used in building construction. As China rolls out basic electrification to its vast rural provinces and builds its factory base, demand for these materials will continue to grow.

Valuation and Outlook

Australia is a developed industrialized country not dissimilar to the U.S. or Britain. However, despite a nice run-up in recent years this market still trades at a considerable discount to the S&P 500 -- 14.6 times trailing earnings versus over 17 for the S&P 500. That valuation discount seems unwarranted given Australia's solid growth prospects and developed, stable political climate.

On top of that valuation discount, Australia is a very attractive market for yield-oriented investors. Despite several major dividend hikes from S&P 500 companies in recent quarters, the yield on the S&P 500 currently stands at about 1.86%. EWA sports a yield almost twice that size at about 3.42%.

DIVIDEND ISHARES (DVY, $62.08)

Overview

The Dividend iShares invests in a group of some of the highest-yielding components of the S&P 500 Index. However, DVY is a lot more than a simple basket of high-yielding large cap stocks -- the index also requires that all stocks have a positive five-year dividend growth rate. In addition, its constituents boast dividend payouts (defined as the percentage of earnings paid as dividends) that do not exceed 60%. As such, real estate investment trusts (REITs) are excluded from this group.

Growth Drivers

Although you might think growth and dividends are mutually exclusive, they aren't. Income stocks have outperformed the S&P by an average of 2.7% per year since 1980. To put that into perspective, for a $50,000 investment over 25 years, a 2.7% return differential is worth just under $50,000.

In the long run based on rolling averages, equity returns for the S&P 500 have been between 6.5% and 7%. Historically, yields for the index have been in the 3.5% to 4% range. That means that for an investor holding a basket of stocks over a 20-year or longer time frame, dividends make up, on average, about 50% of overall returns. That's hardly a trivial figure.

Bottom line: Dividends will continue to represent a large portion of overall stock returns in the long run. As such, even fairly aggressive growth investors should have some exposure to high-quality dividend stocks.

Valuation and Outlook

With a P/E ratio of just a little over 14, DVY actually trades at a considerable discount to the S&P 500. We'd expect these stocks to trade at a slight discount due to their lower earnings growth rates as compared to the S&P 500. However, the fund's dividend yield of about 3.6% more than makes up for that growth differential.

Over the past year DVY has outperformed the S&P 500 by over 3%, and we expect that outperformance to continue as investors look for the relative defensiveness of dividend-paying stocks. What's more, recent tax cuts on dividends enacted by the Bush Administration have also made dividend-paying stocks more attractive than ever before.

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We sincerely hope you've enjoyed today's look at several leading exchange-traded funds (ETFs). Please stay tuned for our next full issue, which we'll publish on Monday, March 21st. In it, my staff and I will examine the importance of free cash flow. We'll then introduce you to several companies that appear to be exceptional bargains relative to their enormous annual cash flows. In the meantime, good investing in the week ahead!

Paul Tracy will be available to take your questions until Monday, March 21. Please use the form below to submit your questions.