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.

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

A basket of stocks
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, along with some additional 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 our participants have rated as the best.

ETF

1 Year Return

CAPS Rating (Out of 5)

iShares FTSE/Xinhua China 25 Index (AMEX: FXI  )

124.08%

****

PowerShares Golden Dragon Halter USX China (AMEX: PGJ  )

108.39%

****

iShares MSCI Brazil Index (AMEX: EWZ  )

95.15%

*****

Claymore/BNY BRIC (AMEX: EEB  )

93.36%

****

iShares S&P Latin America 40 Index (AMEX: ILF  )

73.21%

*****

BLDRS Emerging Markets 50 ADR Index (AMEX: ADRE  )

66.24%

*****

iShares MSCI Singapore Index (AMEX: EWS  )

63.35%

*****

Source: Yahoo! ETF Center. As of Oct. 15. CAPS Ratings courtesy of Motley Fool CAPS.

Although there are many ETFs to choose from, it's only recently that they've gained in popularity. As a result, few of them have been around for any significant amount of time. For example, iShares FTSE/Xinhua China 25, PowerShares Golden Dragon Halter, and Claymore/BNY BRIC don't have three year-returns, which is an arguably important performance milestone. Of course, even venerable mutual funds had to start somewhere, so only time will tell whether these ETFs can build as solid of a track record.

An international flavor
Not surprisingly, all of these top-performing ETFs represent international markets. It probably should come as even less of a surprise that four of them include the world's fastest-growing economy -- China. It's that growing market that attracted CAPS All-Star leperking, who says the underlying shares are what makes one of these ETFs so attractive.

This equity represents the performance of the largest companies in the Chinese equity market that are available to international investors. It invests in 25 of the largest and most liquid Chinese companies. It should follow the trend of the growing Chinese economy!

Numerous CAPS investors, All-Stars and otherwise, have pointed to their belief that China's gross domestic product growth will surpass that of the U.S., so investing in this ETF is a way to play that growth. CAPS player nino347, with a 97.70 player rating, says simply:

I believe that the Chinese market is going to outperform the U.S.; therefore, this is the best way to buy the Chinese market.

Yet China has its share of All-Star bears who think the Chinese economy has grown too far, too quickly. CAPS participant fransgeraedts, with a 95.30 player rating, says:

A pick within the theme of growing risk-aversion in the stock-markets. While there is not yet the kind risk allergy that almost brought the international credit system to a hold, risk-aversion is growing within the stock markets as well. That will mean among other things that the China plays will underperform for a while.

A basket of opinions
Although ETFs have been around since the 1990s, investors might want to be cautious with the ones that don't have a long track record. Give your opinion over at CAPS on whether you think these ETFs will continue to outperform, or whether it might be time for new ones to ascend to the top of the lists.


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