ETFs for Tomorrow

Investing in index funds can be a good enough Foolish strategy that an investor wouldn't have to go beyond them to build a financially rewarding portfolio. You get instant diversification across a broad cross-section of industries, the ability to stop worrying about timing the market, and low costs. Putting an investment program of automatic contributions into an index fund gives Investor Jane the benefits of dollar-cost averaging and saving regularly for the future. Warren Buffett once noted that his favorite time to sell was "never," and investing in index funds allows you to be just like the Oracle of Omaha.

There are a few disadvantages to index investing, however. You never earn exactly what the market earns. Even for super-low-cost funds like the Vanguard Total Market Stock Index, costs are minimal, but they still reduce your returns to slightly below what the market offers.

That could explain why exchange-traded funds have become so popular. According to index-investing legend John Bogle, their assets currently total $420 billion of the $1 trillion of the equity held in index funds.

ETFs, originally modeled after index funds, are mutual funds that trade like stocks. The so-called ETF "Spiders" offered potentially even lower expense ratios than index funds and possibly higher tax efficiency. That you could trade ETFs like stocks only added to their popularity, though increased tax and trading costs can easily erase any benefits from buying and holding an ETF.

Yet as ETFs proliferated, the ability to focus on more specialized areas of the market became possible. That's been a boon to investors seeking to home in on certain areas of the market and buy a basket of stocks there. But it also concentrates the risk that accompanies such specialization and tilts a portfolio away from the broad diversification that makes index investing attractive.

Today, we're looking at the best-performing exchange-traded funds over the past three months and then combining that information with the views of the collective intelligence of the professional and novice investors at Motley Fool CAPS to see which funds have been rated the best.

Only two of these funds have a history of at least a year: Vanguard Materials and Telecom HOLDRS. The others are relatively new funds. You should also note that HOLDRS are a little different from ETFs in that they track a basket of stocks instead of an index, so that there is very little turnover but even more concentration of risk.

Although the Pacific ex-Japan ETF is highly rated among CAPS players -- All-Star WyattKaldenberg says it's a "good way to catch high-paying div[idend] stocks in the Pacific" -- investors might want to be cautious with ETFs that don't have a long track record. ETFs have been around since the 1990s, and we'll check up next time on those funds that have been top performers for longer periods of time.

Fool contributor Rich Duprey does not own any of the funds mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.