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Seven ETFs to watch in 2006

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Focus on gold, financials, energy, emerging markets
By John Spence, MarketWatch
Last Update: 12:03 AM ET Jan 2, 2006

BOSTON (MarketWatch) -- Exchange-traded funds concentrated on energy and emerging-markets stocks took the spotlight in 2005, but ETFs focused on out-of-favor sectors may light up 2006.

Large-cap growth funds and technology funds gathered momentum going into the new year, and will be among the most closely watched ETFs in 2006.

Investors will also likely focus on ETFs -- baskets of securities which trade on exchanges like stocks -- that track financials, homebuilders and gold, along with a controversial new fund that favors companies based on fundamentals instead of market valuation.

Here are seven ETFs to watch in the new year:

Energy Select Sector SPDR

Given the surge in crude oil prices, Energy Select SPDR (XLE: news) not surprisingly was among the top-performing ETFs in 2005, gaining 39.6% through Dec. 29, according to investment researcher Morningstar Inc.

Top holdings include Exxon Mobil Corp. (XOM: news) , Chevron Corp. (CVX: news) and ConocoPhillips (COP: news) . A cold winter could be a boon for this ETF if heating costs rise, and investors will monitor OPEC's oil output and how quickly the damaged Gulf Coast facilities come back online.

Other energy ETFs to consider: iShares Dow Jones U.S. Energy (IYE: news) , Oil Service HOLDRS (OIH: news) and Vanguard Energy Vipers (VDE: news) and PowerShares Dynamic Energy Exploration & Production (PXE: news) .

iShares S&P 500 Growth

Last year, many analysts called for large-growth companies to lead the market after trailing smaller value stocks for years, but the transition didn't materialize.

iShares S&P 500 Growth (IVW: news) rose 4.6% through Dec. 29 according to Morningstar, while iShares S&P SmallCap 600 (IJS: news) gained 6.7% for the same period.

"Given the way large-growth stocks have lagged the rest of the market in recent years, one might expect ETFs focused on them . . . to look relatively undervalued," wrote Dan Culloton, Morningstar senior fund analyst, in recent commentary posted on the firm's Web site.

Yet Culloton notes the funds "actually are mixed bags valuation-wise," with Microsoft Corp. (MSFT: news) , Boston Scientific Corp. (BSX: news) and Dell Inc. (DELL: news) looking attractively priced.

On the other hand, Google Inc. (GOOG: news) , UnitedHealth Group Inc. (UNH: news) and oil-services firm Schlumberger Limited (SLB: news) appear richly valued, Culloton added.

The index for the iShares S&P 500 Growth ETF recently overhauled its investment process, and Barclays Global Investors says it has already rebalanced the fund to reflect the benchmark change. See ETF Focus.

Competing large-cap growth ETFs include iShares Morningstar Large Growth (JKE: news) , iShares Russell 1000 Growth (IWF: news) , PowerShares Dynamic Large Cap Growth (PWB: news) , StreetTracks Dow Jones Wilshire Large Cap Growth (ELG: news) and Vanguard Growth Vipers (VUG: news) .

PowerShares Dynamic Building & Construction Portfolio

ETFs focusing on the homebuilding sector may be late to the party. In late October, the PowerShares Dynamic Building & Construction Portfolio ETF (PKB: news) began trading.

If the housing market deflates in 2006 after a multi-year run and momentum investors seek other shelter, this fund could take a hit. Aside from homebuilders, the PowerShares ETF also holds stocks from related industries such as home-improvement retailers such as Home Depot Inc. (HD: news) and Lowe's Companies Inc. (LOW: news) .

State Street Global Advisors and Barclays Global Investors have also filed ETFs focusing on homebuilder stocks that will likely start trading in 2006, although investors may want to approach these trendy offerings with caution. See ETF Investing.

StreetTracks Gold Trust

The warm reception of gold ETFs was one of the big investment stories of 2005.

Launched in Nov. 2004, the StreetTracks Gold Trust (GLD: news) has amassed $4 billion in one of the most successful fund launches ever. The iShares Comex Gold Trust, which began trading in January, has gathered $361.9 million.

The StreetTracks Gold Trust has performed well, gaining 14.5% in the year, with gold futures recently topping $500 for the first time since 1987. While gold ETFs can be used as an inflation hedge in small doses, gold is notoriously volatile and these funds could see big price swings.

Financial Select Sector SPDR

There are mixed signals here. An inverted yield curve isn't a good sign for banks that borrow money at short-term rates and lend at long-term rates in the so-called carry trade. That could hit broad financials ETFs such as Financial Select Sector SPDR (XLF: news) , iShares Dow Jones U.S. Financial Sector (IYF: news) and Vanguard Financial Vipers (VFH: news) .

However, some analysts are positive on the sector for 2006.

"Managers believe the economy is growing and expect the Fed tightening cycle to end soon -- setting the stage for the financial services sector to prosper," said Randy Lert, chief portfolio strategist at Russell Investment Group, in recent commentary.

"Managers may also be expecting strong performances by investment banks and financial institutions that specialize in regional mortgages," Lert added.

iShares MSCI Emerging Markets

Emerging markets funds soaked up cash in 2005, with U.S. investors looking overseas for growth, and $10 billion iShares MSCI Emerging Markets (EEM: news) was a popular ETF choice for inexpensive, diversified exposure.

The fund rose 32.7% in the year, buoyed by dollar weakness relative to foreign currencies. Highflying stock markets in Latin America and Asia have generated much of the steam.

Recognizing cheaper stock valuations than U.S. markets offer, investors piled into hot-performing emerging markets, but some analysts are worried about a cooling-off period in 2006.

Other emerging markets ETFs include BLDRS Emerging Markets 50 ADR (ADRE: news) , which invests in the American Depository Receipts of foreign companies, and Vanguard Emerging Markets Vipers (VWO: news) . Many financial advisers recommend a small allocation to emerging-markets funds -- usually 5% of portfolio assets and typically no more than about 10%.

PowerShares FTSE RAFI U.S. 1000 (PRF)

ETF upstart PowerShares Capital Management made headlines in 2005 by launching ETFs at a furious clip, but none could be more closely watched than one introduced at the end of the year.

Building on its "enhanced index" strategies, the firm rolled out an ETF based on "fundamental" indexing strategies developed by investment manager Robert Arnott. The PowerShares FTSE RAFI U.S. 1000 Portfolio (PRF: news) is listed on the New York Stock Exchange, which itself is trying to beef up its ETF business.

Rather than positioning companies by market capitalization, like most traditional indexes, the Research Affiliates Fundamental Index (RAFI) series weight stocks by fundamental factors such as cash flow, dividends, book value and sales. See ETF Focus.

In his research, Arnott contends that his indexing strategy outperforms conventional benchmarks because it doesn't lean towards companies that have enjoyed significant share-price appreciation. Investors will watch to see if what has worked in theory can perform in reality.

Seven ETFs to watch in 2006
Energy Select Sector SPDR (XLE: news) 39.6%
iShares S&P 500 Growth (IVW: news) 4.6%
PowerShares Dynamic Building & Construction Portfolio (PKB: news) n/a
StreetTracks Gold Trust (GLD: news) 17.5%
Financial Select Sector SPDR (XLF: news) 6.8%
iShares MSCI Emerging Markets (EEM: news) 32.7%
PowerShares FTSE RAFI U.S. 1000 (PRF: news) n/a

Source: Morningstar Inc. Year-to-date returns through Dec. 29 close. Data not shown for ETFs launched after Jan. 1, 2005.

John Spence is a reporter for MarketWatch in Boston.