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This ETF Sector Is Getting Pricey

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With the stock market having doubled since its trough back in March 2009, before falling back a bit recently, there aren't as many bargains floating around as there once were. While stock pickers can likely continue to find undervalued and unloved companies on a stock-by-stock basis, the issue of generally higher valuations becomes more of a problem for investors who prefer exchange-traded funds.

Since ETF investors are buying broad exposure to certain sectors or areas of the market, they can't easily exclude more expensive companies from their portfolio if the ETFs they own buy them. And there's one sector of the market that is looking increasingly pricey nowadays.

Less bang for your buck
While large-cap stocks dominated in the late 1990s, small-cap stocks have had a truly amazing run in the decade since then. Over the 10-year period from May 2001 through April 2011, the small-cap Russell 2000 Index posted a cumulative 103% return, compared to a 32% showing for the S&P 500 Index. And while few small-cap investors can quibble with those returns, higher returns also lead to higher valuations. In fact, by historical measures, the small-cap sector is looking somewhat vulnerable.

As a recent Wall Street Journal article highlighted, the Russell 2000 Index is trading at roughly 18 times one-year forward earnings forecasts. That P/E ratio is about 30% higher than the P/E ratio of the market's 200 largest companies, as measured by the Russell Top 200 Index. That is the highest recorded gap since 1979, when such data began to be collected.

Furthermore, in the past, when the valuation gap approached current levels, as it did in 1983 and 2007, small caps underwent a period of underperformance compared to their large-cap counterparts. Given that small-cap stocks are so historically expensive in comparison to larger names, odds are good that they will underperform in the next stage of the market cycle.

Trimming risk
But even though small-cap exchange-traded funds may not be as value-priced as they once were, I don't recommend fleeing the sector entirely. It's impossible to time the market exactly, and you definitely want the growth potential that smaller names offer in your long-term plan. Stick with your small-cap ETFs, but think about putting new money and new retirement contributions to work in the higher-potential large-cap arena. If you haven't already, use this as an opportunity to rebalance your portfolio. If you're overweighted in small-cap names because of their solid performance, make sure you sell off some of those holdings and reallocate that money into funds that invest in larger stocks to get your long-term asset allocation back in line.

If you own some of the better small-cap ETFs, such as the iShares Russell 2000 Index (NYSE: IWM  ) , Vanguard Small Cap ETF (NYSE: VB  ) , or SPDR S&P 600 Small Cap ETF (NYSE: SLY  ) , exercise some caution. Moderate your expectations for the sector, and don't plan on another extended run of top-tier performance. Small caps tend to do well in the initial stages of a market and economic rebound, and if history is any guide, larger names will take over market leadership soon. Keep your small-cap holdings, but pare back a bit to protect your portfolio against a likely shift in market sentiment.

Large and in charge
Of course, even if large-cap blue chips end up being the next big market winners, and I think they will, investors should still keep expectations in check. We're almost certainly not going to see the market double again in the next two years, or even five years. But given current valuations, higher-quality large-cap stocks likely have the most room to run.

Fortunately, there are a number of well-diversified, low-cost ETFs that focus on this area of the market. My favorites include SPDR S&P 500 ETF (NYSE: SPY  ) and iShares S&P 500 ETF (NYSE: IVV  ) . Both funds will only set you back 0.09% a year. If you want to narrow the field down further to top-drawer, dividend-paying large caps, consider Vanguard Dividend Appreciation ETF (NYSE: VIG  ) or SPDR S&P Dividend ETF (NYSE: SDY  ) . With price tags of 0.23% and 0.35%, respectively, both are solid options for gaining a foothold on a relatively undervalued market segment.

ETF investors have already realized that these investment vehicles are one of the cheapest and most efficient tools for creating a well-diversified portfolio. With just a few easy tweaks, investors can better align their ETF portfolio to reflect today's valuations and tomorrow's opportunities.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Try any of our Foolish newsletter services free for 30 days.

The Fool has created a ratio put spread position on iShares Russell 2000 Index ETF. Motley Fool newsletter services have recommended creating a short position on iShares Russell 2000 Index ETF. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. 

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