When looking to evaluate ETF’s, MarketGrader’s new ETFGrader application adopts a bottom-up approach based on our fundamental analysis. Utilizing StockGrader , we analyze each component’s fundamentals and issue an overall rating for each company in the ETF. We then calculate a weighted average of all components in the ETF, based on the underlying index’s calculation methodology, to arrive at its average overall grade, which is therefore derived from the fundamental strength of its components.

The fundamental rating that we assign each component takes into account four main indicators and 24 sub-indicators. The four main indicators are: Growth, Value, Profitability, and Cash Flow. Each indicator is divided into six sub-indicators such as Growth Potential, Capital Structure, Return on Equity, and Debt/Cash Flow Ratio. The grades for all indicators are then compiled into our overall company rating, or overall grade. Once we have our component ratings, we then calculate our ETF ratings based on a weighted average that takes into account both the components of the ETF and the weight in the portfolio.

Currently the 5 highest rated sector ETF’s in MarketGrader all belong to the Technology sector, and, more specifically, 3 of the 5 track the Semiconductors industry. The following is the list of our top 5 ETF’s complete with their average ETF grade and rating, their average sentiment, the two highest rated components, and the two lowest rated components. Note that grades that are 60 or higher denote a “Buy,” grades between 50 and 60 denote a “Hold,” and grades below 50 denote a “Sell.”

1. HOLDRS Semiconductor (SMH)

HOLDRS Semiconductor received an ETF average grade of 77.8 (out of 100). The market sentiment for SMH is currently positive. The two highest rated components in SMH are Intel Corp (INTC), which has an overall grade of 91.8 and Altera Corp (ALTR), with an overall grade of 86.0. The two lowest rated components are LSI Corp (LSI), with a 46.8, and National Semiconductor Co (NSM), with a 59.4.

2. IShares PHLX SOX Semiconductor Sector Index Fund (SOXX)

IShares PHLX SOX Semiconductor Sector Index Fund received an ETF average grade of 72.0. The market sentiment for SOXX is currently neutral. The two highest rated components in SMH are Intel Corp (INTC), with an overall grade of 91.8 and Cirrus Logic Inc (CRUS), with an 89.0. The two lowest rated components are NXP Semiconductors NV (NXPI), with an overall grade of 27.7, and NetLogic Microsystems Inc (NETL), with a 30.3.

3. IShares Dow Jones U.S. Technology Index Fund (IYW)

IShares Dow Jones U.S. Technology Index Fund received an ETF average grade of 71.8. The market sentiment for IYW is currently neutral. IYW’s two highest rated components are Intel Corp (INTC), with an overall grade of 91.8 and Apple (AAPL), with an 88.0. The two lowest rated components are Ciena Corp (Cien), 18.7, and Diebold Inc (DBD), 19.1.

4. HOLDRS Internet Architecture (IAH)

HOLDRS Internet Architecture received an ETF average grade of 71.8. The market sentiment for IAH is currently positive. IAH’s two highest rated components are Apple (AAPL), 88.0, and Hewlett Packard (HPQ), with an overall grade of 72.2. The two lowest rated components are Sycamore Networks Inc (SCMR), 14.6, and Ciena Corp (CIEN), 18.7.

5. Powershares Dynamic Semiconductors (PSI)

Powershares Dynamic Semiconductors received an ETF average grade of 71.8. The market sentiment for PSI is currently positive. PSI’s two highest rated components are Kulicke and Soffa Industries Inc (KLIC), which has an overall grade of 93.5, and Veeco Instruments (VECO), with an 87.2. The two lowest rated components are NVidia Corp (NVDA), with a 44.2, and Electro Scientific Industries (ESIO), with a 54.2.

For the complete rankings of al sector or industry based ETFs in MarketGrader, please click here.

Following the Federal Reserve’s announcement last Friday that some banks may be held to higher capital requirements that correspond with the bank’s importance to the financial system (MarketWatch), investors have been bearish on financial stocks, especially large cap banks. The impact of this announcement is evident in companies such as Citigroup (C), which dropped 4.5% on the trading day after this announcement.

Year to date the S&P 500 Financial Index, which underlies the popular XLF ETF is down 6.6% while MG Financials is up 2.5% in the same period. These are price-only returns of the indexes and exclude dividends or the costs of owning a fund or ETF. Over a longer period of time, MG Financials’ out performance is even more remarkable. Based on three-year price only cumulative returns, as of yesterday’s close, MG Financials has outperformed the S&P 500 Financials Index by more than 38 percentage points.

3-Year Price-Only Cumulative Returns:

MarketGrader Financials Index:   +2.53%

S&P 500 Financials Index:    -35.89%

While some of this performance can be attributed to the fact that MG Financials is equally weighted, and thus not overly exposed to the mega-cap banks that crashed during the 2008 financial crisis, a good deal of the performance is also owed to sound stock selection and a disciplined rebalance approach. A few examples of its constituents appear below.

How is the index constructed?

The MG Financials Index consists of the 40 highest rated financial stocks (based on fundamental analysis) on MarketGrader.com and is rebalanced quarterly, with the last shuffle having taken place at the end of May.

As of June 7, 2011, the 3 highest rated stocks on the MG Financial Index were:

Anally Capital Management (NLY)- rated 84.4/100

Chimera Investment Group (CIM)- rated 81.9/100

Ares Capital (ARCC)- rated 80/100

The 3 stocks in the index with the largest YTD gains are:

Encore Capital (ECPG)- up 37.87%

Cash America International (CSH)- up 34.23%

Credit Acceptance Corp (CACC)- up 21.91%

When using ETFGrader to compare the MG Financials to an ETF that tracks the returns of the S&P 500 Financial Index, such as SPDR Financial Select Fund (XLF) we can see how these gains are possible. The MG Financial Index has an average rating of 68.23, whereas XLF has an average rating of 52.9. This reflects the fact that the MarketGrader Index consists of fundamentally stronger companies, which is reflected in the returns of the two indexes.