A Big Year for ETFs

Not only did 2006 bring us new ETFs springing up like jack-in-the-boxes to cover various market niches, but it was also the year in which this investment product showed how powerful it can be for individual investors. You didn't need to stray any further than your computer or phone to invest in many profitable corners of the globe. ETFs made it easy and relatively inexpensive to get exposure to far-flung reaches of the planet, and if you picked the right country, the returns were eye-popping. Looking ahead, we may find some lessons from the ETFs that shone over the past year.

Go global
The top five ETFs in 2006 were, with one exception, a non-U.S. story. These strong returns follow a somewhat similar pattern as that of 2005, when non-U.S. energy- and natural resource-based funds outperformed the rest of the market. In '06, China moved to the fore with two impressive funds -- the iShares FTSE/Xinhua China 25 Index (NYSE: FXI  ) , which had an 84% return, and the PowerShares Golden Dragon Halter USX China (AMEX: PGJ  ) , which came in with a 55% return. Single-country funds from opposite sides of the globe also made it into the top five funds: The iShares MSCI Spain Index was up strongly with a 49% return, while the iShares MSCI Singapore Index came through with a 45% return. Ironically, the Internet Infrastructure HOLDRs,which were at the bottom of the ETF pile in 2005, rebounded with a 43% return in 2006 to secure a slot in the top five ETFs.

Performance continuation?
Dig a little deeper, into the top 10 ETFs of 2006, and the only other exception to the non-U.S. funds dominance is a surprising one -- the First Trust Value Line Dividend Index fund (AMEX: FVD  ) . Tax-law changes and the recent emphasis on dividends have helped make this fund a top performer.

Global markets have been hot, and that trend could continue. The big question is whether countries that outperformed this year will continue their run, or whether a new region or country might shine in 2007. My bet would be on the latter option. In 2005, the iShares funds for both Latin American and South Korea were top performers, with respective returns of 55% and 54%. Neither of these funds made the top 10 ETF list in 2006.

Reversal of fortune
Internet-related funds dominated the list of worst-performing ETFs in 2005. And once again in 2006, some of the worst-performing funds were Internet and technology-related. The Internet HOLDRs (AMEX: HHH  ) were down 20%, and the Biotech HOLDRs (AMEX: BBH  ) fell 9%.

In a 180-degree turnaround, several of the top losers in 2005 surprised investors with outstanding returns in 2006. Pick the right fund from these bottom-feeders, and one year later, you could have done quite well. The Internet Infrastructure HOLDRs, as previously mentioned, was the best ETF turnaround. The Telecom HOLDRS (AMEX: TTH  ) went from a nearly 10% decline in 2005 to a roughly 32% positive return in 2006.

Of course, some ETFs at the bottom in 2005 continued their negative performance. There was a stark difference in returns if you selected the wrong fund. The B2B Internet HOLDRS (AMEX: BHH  ) , for example, lost nearly 11% in 2005 and continued that trajectory in 2006 with a 16% decline.

If the change in fortune for some of the laggards of 2005 is any guide, there may be a few diamonds among the detritus of 2006. Even with hindsight, it's hard to say why some losers in 2005 were the lucky ones in 2006, but if you can distinguish the good from the bad, it is well worth the effort.

Trends to ponder
The economic fundamentals still seem to be well positioned for the coming year. Of course, there is no telling what unforeseen event may shock the markets and change the picture. Several big uncertainties already on most investors' radar screens are Iraq, Iran, and North Korea.

The United States has been the world's economic powerhouse for a number of years, with consumers soaking up supply from all corners of the planet. Now that Europe and Asia are ascendant and playing bigger roles in the global economy, the U.S. may not be the place to bet on, at least for extraordinary returns.

The residential real estate market is experiencing a sharp rise in inventory, which is good news for shoppers who will have more choices. Housing prices rose so long and so far that their decline, historically sticky, probably has a way to go and has not yet reached bottom. Overall, this seems like an area to stay away from unless select opportunities arise.

Energy seems to have found a new price level, which turns both the traditional suppliers and alternatives into interesting places to hunt. Alternative energy and clean tech have lots of promise, and if energy prices stay at these levels, companies in these areas may benefit.

With new and innovative ETFs sprouting like mushrooms after a rain, there will no doubt be many additional choices for investors in the coming year. The new crop of ETFs should be carefully culled before being added to your portfolio. Some of these funds are gold nuggets, and others are fools' gold. It is foolish not to figure out which of these you are buying before investing.

Foolanthropy is celebrating its 10th year! To learn more about our five Foolish charities or to make a donation, visit www.foolanthropy.com.

For more on the world of exchange-traded funds, check out our ETF Center.

Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds mentioned in this article. The Motley Fool has a disclosure policy.


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