Market Breakdown By Recent ETF Performance

August 16, 2004

The 2003 stock rally, which catapulted every US equity-focused ETF at year end into positive territory, has continued during the first six months of 2004-but more cautiously. Returns have been mixed over the first two quarters for ETFs, and gains have not been as dramatic or widespread as in 2003.

Two discrete groups of ETFs outperformed from January to June, the first was an ex-US country play, the other, a sector bet. iShares Austria (EWO) topped the charts with a 26% positive return, while energy and semiconductors hovered around 15%.

Given the geo-political climate, it's not surprising that the best performing sector from January through June was energy. Oil companies have credited higher global oil prices, which in turn have led to higher net incomes.

Winners and losers

The Select Sector Energy Spider (XLE), for example, was up about 15%, says Christopher Traulsen, head ETF analyst for Morningstar. Oil and gas companies make up nearly 79% of its basket, of which Exxon Mobil Corp is 22.6% and Chevron Texaco Corp is 15.9%.

Similar to XLE, but designed by BGI, is the iShares Dow Jones US Energy fund (IYE), which was up 14%, says Traulsen. Its holdings are very similar to the Energy Spider, only the weightings vary. Energy comprises 99.6% of IYE, of which Exxon Mobil and Chevron Texaco are 23.2% and 21.9% respectively.

In addition to energy, networking ETFs were also strong contenders. The iShares GS Networking (IGN) was up about 14.8%, "continuing the bounce seen at the end of 2003," says Traulsen. "Investors are still optimistic about the prospects of some companies in the fund."

This ETF has had a remarkable recovery. At the end of 2002, IGN was down 54.4%, only to surge to a positive 103% one year later. Its continued relative success is due, says Traulsen, to its top holdings.

IGN is a highly concentrated fund, composed of but two sectors: Multimedia networking, which is 85.6% of the ETF, and semiconductors, which is 14.4%. Qual-comm Inc is 9% of its assets and its up 30% through June. Motorola is 9.7% of its assets and it's up 15.6% through June. Corning is 7.3% of the fund, and its up 16% through June.

These were names that were crushed during the bear market, came back sharply last year, and may still have a room left for growth. Interestingly, Nortel, which makes up 10.0% of the fund, has continued to have problems this year, Cisco, which is 6.4%, hasn't done well. "But in a concentrated port-folio such as the GS Networking, the winners are enough to make a difference in overall performance," he says.

After energy and networking, industrials and small and midcap value were relatively strong. The Select Sector Industrial Spider (XLI) was up 7.3%, the iShares Russell 2000 Value (IWN) was up 7.8% and the iShares Russell Midcap Value (IWS) was up 7.0%, according to Morningstar data.

Industrials in general have benefited from the economic recovery, boosting areas such as transportation and defense, which again are related to the geopolitical environment, says Traulsen. "In many cases, XLI components are just flat out cyclical, and as the economy recovers, so do these stocks."

Industrial conglomerates comprise 32.1% of XLI, and aerospace and defense, 17.7%. General Electric Co is the largest stock in this ETF, accounting for 20.3% of its assets. Up roughly 9% through June, GE's performance has had a large impact on XLI's positive performance, says Traulsen.

"GE is not just industrials, it's a huge conglomerate with a big finance arm, for example," he says. XLI has benefited not only from the overall industrial rally, it has also benefited from GE's success, which is partly driven by its other businesses.

Conversely, one of the worst performers was the iShares GS Semiconductors fund (IGW). This fund, which was down 5.8% through June, had been up 81.0% at the end of 2003. "Broadly speaking, the tech sector this year gave back its previous gains, with the notable exception of networking," says Traulsen.

Looking at a smattering of tech ETFs, the iShares DJ Technology fund (IYW), for example, was down about 1.0%, while the iShares GS Technology fund (IGM) was up about 0.4%, and the iShares GS Software fund (IGV) was up about 0.5%. Similarly, the Select Sector Technology Spider (XLK) was up 0.9%, and even though it has done better than the other broad technology ETFs, it was the 27th worst out of 134 US-based ETFs, says Traulsen.

Ex-US plays

Country specific ETFs also did well this year, as investing ex-US continued its allure due, in part, to dollar weakness. Most non-dollar ETFs have seen heightened activity over the last couple of years as investors sought new vehicles for cash equitization or to achieve alpha.

The top country performer through June was the iShares MSCI Austria (EWO), up 26%. With but 18 stocks in the fund, EWO is sector heavy with banks comprising 26.0% of the fund, materials, 18.2%, telecommunications, 17.3%, and energy 10.9%.

Senior Morningstar analyst, Bridget Huges, describes EWO as a highly concentrated fund. Its largest holding Erste Bank der Oesterreichischen Sparkassen AG comprises 21.4% of the fund, and was up 28%.

Erste is a growth story, having invested successfully in several Czechoslovakian banks, says Hughes. While its second largest holding, Telekom Austria AG, which is 17.3% of the fund, was up 24%. These top two holdings are nearly 40% of EWO, enough to bump it into first place.

Coming in second was the iShares MSCI Mexico (EWW), up 14.6%. Like the energy and semiconductor ETFs, and the iShares Austria as well, Mexico's return was largely a stock story, says William Rocco, a Morningstar analyst specializing in emerging markets.

Of the sectors comprising EWW, 44.6% is devoted to telecommunications, a space that outperformed due to wireless, says Rocco. Three of its top five holdings did exceptionally well, with America Movil SA de CV, which is 22.7% of the fund, up some 30%, he says.

At the end of 2003, iShares MSCI Brazil (EWZ) was the best international performer, up 116.1% for that year. Some six months later, it was the worst performer, down 12.6%. In general, expectations regarding Brazilian president Lula da Silva have not been met, which increased outflows, says Traulsen. Also, the real declined on fears that US interest rates might rise sooner and faster than expected.

Looking ahead, analysts suggest that ETF winners, while difficult to predict especially in an election year, will still focus on the blue chips. Earnings projection for the S&P 500, for example, is expected to set a record in 2004, says Howard Silverblatt, Standard & Poor's equity market analyst.

However not all sectors are expected to gain equally. Information technology will gain the most, partially due to a continuing recovery from negative earnings in 2001, while lagging performance is expected from telecommunications services, says Silverblatt.