ETFs for Tomorrow

Investing in index funds could be all the Foolish strategy you need to build a financially rewarding portfolio. You get instant, low-cost diversification across a variety of industries, and you never have to worry about timing the market.

Making automatic contributions into an index fund gives an average investor the benefits of dollar-cost averaging, making it easy to save regularly for the future. Warren Buffett once noted that his favorite time to sell is "never," and in that respect, index funds let you invest just like the Oracle of Omaha does.

That could explain why exchange-traded funds are so popular. According to the Investment Company Institute, ETF assets totaled more than $507 billion of the more than $1 trillion in stock index funds as of August.

A basket of stocks
ETFs, originally modeled after index funds, are mutual funds that trade like stocks. The first batch of ETFs, known as SPDRs ("spiders"), offered even lower expense ratios than many index funds, along with some additional tax efficiency. The ability to trade ETFs like stocks added to their popularity, although Fools should note that increased taxes and trading costs can erase any benefits from buying and holding an ETF.

As ETFs proliferated, they gradually narrowed their contents, from broad indexes to specialized slices of the market. That's been a boon to investors seeking to home in on certain areas of the market by buying a basket of related stocks. But it also concentrates the risk that accompanies such specialization, tilting a portfolio away from the diversification that makes index investing attractive.

Today, we're looking at ETFs with portfolios that have the lowest price-to-sales ratio. Although the ratio has its limitations, famed analyst James O'Shaughnessy explains in his book, What Works on Wall Street, that low price-sales stocks (companies with ratios below 1.5) indicate bargains in the market. An ETF composed of such stocks might itself represent a bargain.

ETF	Net Assets	Portfolio P/S Ratio	1-Year Return	CAPS Rating (Out of 5)
iShares Dow Jones US Home Construction (AMEX:ITB)	$205.00 million	0.25%	(45.84%)	*
SPDR S&P Homebuilders (AMEX:XHB)	$444.43 million	0.27%	(34.01%)	*
Rydex S&P SmallCap 600 Pure Value (AMEX:RZV)	$22.43 million	0.34%	1.15%	****
Rydex S&P MidCap 400 Pure Value (AMEX:RFV)	$21.46 million	0.45%	12.68%	NA
WisdomTree Japan SmallCap Dividend (AMEX:DFJ)	$79.83 million	0.50%	(0.74%)	NA

Source: Yahoo! Finance. CAPS Ratings courtesy of Motley Fool CAPS.

While there are many ETFs to choose from, there aren't many that have long histories. For example, none of these ETFs have three-year returns, an important performance milestone. Of course, even venerable mutual funds had to start sometime, so only time will tell if these ETFs can build as solid a track record over five- and 10-year time periods. Until then, investors are wise to be cautious.

Big things in small packages
Not surprisingly, the housing industry tops the list of funds that have the lowest price-to-sales ratio. Considering that CAPS players dislike them -- they've got one-star ratings -- that ratio also highlights that cheap stocks are sometimes cheap for a reason.

Forgetting for the moment the credit crunch that is ensnaring the industry, builders themselves are contributing to their woes. Price discounts and incentives create a vicious, downward spiral that leads potential buyers to delay making purchases. Why buy a house now if the price will be cheaper next week or next month?

When you're looking at a stock, you can't consider its low price-to-sales ratio in a vacuum, especially if the fundamentals make it likely that the stocks within the ETF still have further to fall. We might be seeing the fund topping this list for a while yet.

In fact, the only fund CAPS investors are generating enthusiasm for is the Rydex S&P Smallcap 600 Pure Value fund. Top-rated All-Star stabfederline, who has a 98.47 player rating, sees that ETF as a top value: "Best small cap value ETF. Slightly high expense ratio though."

The fund's top two stock holdings are food distributor Nash Finch (Nasdaq: NAFC  ) and tableware maker Libbey (NYSE: LBY  ) . And stabfederline is right about the expense ratio being high: At 0.35% it's quite a bit above the 0.12% charged by the Vanguard Small-Cap Value Index ETF.

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