Value investors often gravitate to sectors that have been beaten down. But just because a stock or ETF in a particular sector trades at a low price doesn't mean that it's a smart buy.
Over the past year, ETFs focusing on a number of different areas have seen big price declines. Let's take a closer look at five of them to see whether they're good values or dangerous value traps for unwary investors.
1. Market Vectors Coal (NYSEMKT:KOL), down 28%
The coal industry has been the victim of the basic economic principle of substitution. When natural gas prices were high, coal was the most economical fuel for power generation. But as gas prices plunged, utilities shifted away from burning coal, and that sent prices plunging.
Recently, natural gas has climbed off its lows, nearly doubling from its summer price below $2. Exports have emerged as a potential source of renewed strength for the coal industry, and if the trend takes hold, it could resurrect coal stocks. With substantial holdings in relatively strong industry players like Peabody Energy, the coal ETF could take full advantage of those gains to recover from its substantial losses.
2. Guggenheim Solar (NYSEMKT:TAN), down 22%
Solar stocks have suffered from a big shakeout in the industry, as falling subsidies have challenged the business models of the weaker players in the solar market. With many Chinese solar companies not even managing to have positive gross profit, let alone net income, stocks across the industry have plunged, pulling the Guggenheim ETF down with them.
Lately, the stronger solar stocks have started to see some signs of a turnaround. But because the solar ETF still has substantial holdings of some of the players most likely not to survive the industry shakeout, the ETF may not gain ground even if the best solar stocks in the industry recover fully. You'll be better off making individual bets in the space rather than counting on an industrywide boost to lift the ETF from its losses.
3. United States Oil Fund (NYSEMKT:USO), down 20%
Crude oil prices have fallen slightly in the past year, as plentiful supplies of crude from newly found discoveries in the U.S. have helped hold the price of West Texas Intermediate at extremely low levels compared to globally traded Brent crude. Brent is down about 13% over the past year, while WTI is down about 15%.
But the oil ETF has fallen more sharply because of contango in the oil markets. With the ETF suffering erosion of value every month from having to roll forward its futures contracts, the magnitude of losses is increased. Although a rebound in oil prices would lift the ETF's shares, there's no guarantee that investors will ever get those contango-related losses back.
4. iPath S&P 500 VIX Short-Term ETN (NYSEMKT:VXX), down 77%
One strange attribute of the stock market over the past year has been the nearly complete lack of volatility. Although the markets haven't moved straight up, declines have been shallow and short-lived, and despite potential global and domestic catastrophic events, investors have been complacent. That has sent levels in the S&P Volatility Index to multiyear lows.
Again, though, losses in the volatility ETF have been magnified by its futures strategy. Expectations of higher future volatility have been continually thwarted, costing investors additional friction from rolling contracts. If fear returns to the market, then the iPath ETF will rise, but there's no guarantee that it'll get close to quintupling in price -- which is what it would need to regain its losses since early 2012.
5. Market Vectors Gold Miners (NYSEMKT:GDX), down 28%
Gold-mining stocks have gotten hit far harder than the value of the bullion they produce. Labor strife and rising production costs have eaten into margins even as the bull market in gold prices paused during 2012. Even savvy mine operators saw their shares drop significantly in light of the bad market conditions.
Unlike solar energy, more favorable conditions in gold mining and production could potentially lift shares broadly across the mining industry. Still, with big differences in asset quality and risk, you could fare much better by choosing individual stocks best poised to rebound, rather than playing the field with a broad-based gold-mining ETF.
Bet on the right ETFs
Any beaten-down investment can recover, but successful investors always make sure to put the odds are in their favor. Only by being realistic about a beaten-down ETF's chances at recovering will you stand the best chance to gain from a turnaround.