ETFs for Tomorrow

Index funds have long been a Foolish way to gain instant, low-cost diversification without worrying about timing the market. Their ease and convenience may explain the growing popularity of exchange-traded funds -- mutual funds that trade like stocks. According to the Investment Company Institute, ETF assets accounted for more than $572 billion of the more than $1 trillion in stock index funds as of Nov. 30.

Originally modeled after index funds, ETFs have gradually narrowed to target specialized slices of the market. While that's a boon to investors seeking such targeted investments, it also concentrates the risks of specialization, tilting a portfolio away from the diversification that makes index investing attractive.

Last week, we noted that over the past year, large-cap stocks and funds began to outperform -- or perform less worse -- than their small-cap brethren. We pointed to Fool analyst Dan Caplinger's observation: "Over the past year, large-cap growth funds have risen 8.25%, while large-cap value funds fell nearly 2%. With smaller stocks, the disparity was even more dramatic, with small-cap value funds down over 11%, while small-cap growth funds eked out a 2% gain." 

So we'll take a look this week at those large-cap ETFs with the best three-year performance, sorted by how they've fared over the past 12 months.  

Tread carefully here, Fools. Although the market offers many exchange-traded funds, few have a long history. While all of these have a three-year performance standard -- an arguably important performance milestone -- only time will tell whether they can build similarly solid track records over five- and 10-year periods. You should also note that HOLDRS are a little different from ETFs in that they track a basket of stocks instead of a broad-based index, so there is very little turnover, but even more concentration of risk.

Climbing a wall of opportunity
The Dow Jones Industrial Average is the grandfather of all market measures, going all the way back to 1896, when Wall Street Journal editor and Dow Jones & Co. founder Charles Dow created a basket of stocks to measure the performance of the country's industrial output. Although the 30 stocks comprising the Dow haven't always been industrial -- Microsoft (Nasdaq: MSFT) and Hewlett-Packard (NYSE: HPQ) are a couple of examples -- they still represent a cross-section of the economy that's at least as representative today as the original 12 stocks were when it was first published.

The DIAMONDS Trust ETF owns shares of the Dow 30 companies. Over the 100-year history of the average, the Dow has returned roughly 10%-11% per year. While individual years can obviously be higher or lower, the Dow has typically reverted to the mean after both bull and bear markets. Early last year, the analysts and market researchers at NetScribes saw the Dow -- and thus this tracking ETF -- facing numerous demographic challenges that point toward difficulties for the average.

With a market capitalization slightly in excess of $6.7 billion and top ten stocks making up for almost 50% of the Trust, it returned merely 12.85% as compared to the DJIA return of 13.58%, over the past one year. Thus, the ETF did not outperform the benchmark index. Also, the component stocks of DJIA are viewed as being fully valued, which reduces the possibility of the index and the ETF to post a stunning performance. Coupled with the mind-set of a slowing economy, an unstable interest rate scenario and the omnipresent housing slump story, the Trust fails to appear as a trustworthy performer.

On the other hand, CAPS investor HistoricalPEGuy looked at the price-to-earnings ratio of the Dow components and found it to be an attractive way to spread out your risk in an uncertain market.

Of course, this is just a simple metric. Some of these companies probably deserve to have historically low P/Es due to stagnant future prospects. There is a simple way to spread your risk and not buy a single one of them. When the entire Average starts to look cheap, buy the ETF-DIA. If you are like me and don't want to bail out of equities in the face of impending doom (damn you, Greenspan), the DJIA isn't a bad place to be, especially when [it's] on the cheap and paying dividends while you wait for the market to recover. Speculative stocks will get trampled while blue chips will get a more minor correction, presenting itself with yet another great buying opportunity in a large handful of great companies.

A basket of opinions
Although ETFs have been around since the 1990s, investors should exercise caution with any ETF lacking a long track record. Over on Motley Fool CAPS, let us know whether you think these ETFs will continue to outperform, or whether it's time for new ones to top the lists.