ETFs Win Big, Lose Big

With exchange-traded funds multiplying like rabbits, competition for ETF market share is heating up, even among industry veterans such as Barclays (NYSE: BCS  ) and State Street (NYSE: STT  ) . Firms are rolling out new ETFs by the dozen, with increasingly narrow focuses. As a result, ETF performance has become dramatically segmented; many funds rank either at the extreme top or bottom of their peer groups.

To the extreme
A recent Wall Street Journal article highlighted ETFs' prominent places among the top and bottom Lipper performance rankings for the first five months of 2007. According to this data, 13 of the 60 best and worst funds for this period were exchange-traded funds. This may not seem like a lot, but with 15 times as many mutual funds as ETFs, exchange-traded funds are disproportionately represented here.

The best-performing ETFs for the year include iShares Malaysia (NYSE: EWM  ) and iShares Brazil (NYSE: EWZ  ) , along with a few metals and mining funds. ETFs at the bottom of the pile include the iShares Dow Jones U.S. Home Construction Fund (NYSE: ITB  ) and several of the ProShares leveraged funds.

ETFs' narrowing scopes increasingly land them on either end of the fund bell curve. Funds concentrating on one specific country or sector are far more likely to have periods of extreme good or bad performance than more diversified peers. As more investors flock to these specialized funds, they'll risk encountering periods of highly volatile performance. Many funds currently topping the charts so far this year may just as well end up on the bottom in the next six months.

Think broad
Fortunately, Fools know to avoid these narrowly focused ETFs. Why would any diversified investor need to buy a fund that invests only in Malaysia or Brazil, or focuses exclusively on mining or homebuilding? Investors in these types of ETFs are often only lured in by their recent red-hot returns. Sometimes, a performance streak does continue -- but not often. Fools, beware: Chasing performance is the surest way to lose money and waste your time.

For most investors, diversification is the key to success. Buying into any one of these super-specialized funds won't get the job done. By avoiding specialized ETFs, you may not hit the jackpot of double-digit gains in just a few months, but you'll also avoid the risk of losing a large chunk of your investment when the market decides to punish certain segments or sectors.

If you decide that ETFs are right for you, remember to think big. Stick to broad-market funds tracking a wide swath of the market, not just one sector. If you have a taste for international investing, avoid single-country funds in favor of one that invests across the globe, in both emerging and developed markets. (This applies to regular old mutual funds as well.)

Profit-minded firms will likely continue to roll out new and exciting flavors of exchange-traded funds in the coming months. While these funds may produce tempting returns, always remember that true Fools stay focused on the long term.

More exchange-traded Foolishness:

Whether you're interested in ETFs or traditional mutual funds, find the investments most likely to make money for your portfolio with a free 30-day trial to Motley Fool Champion Funds.

Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. The Fool's disclosure policy is big on moderation.


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