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 totaled more than $568 billion of the more than $1 trillion in stock index funds as of Jan. 31 -- a 32% increase over last year, but down $39 billion from December.

Originally modeled after index funds, ETFs have gradually narrowed to target specialized slices of the market. While that's a boon to investors seeking specifically targeted investments, it also concentrates the risks of 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. We'll then combine that information with the collective intelligence of the 86,000 professional and novice investors at Motley Fool CAPS  to see how our participants have rated them.

ETF	Net Assets	Portfolio P/S Ratio	1-Year Return	CAPS Rating (5 max)
iShares Dow Jones U.S. Home Construction (NYSE: ITB)	$298.0 million	0.23	(50.6%)	*
FocusShares ISE Homebuilders Index	$10.5 million	0.26	NA	NR
Rydex S&P SmallCap 600 Pure Value (AMEX: RZV)	$23.8 million	0.27	(24.5%)	**
SPDR S&P Homebuilders (AMEX: XHB)	$703.6 million	0.32	(40.8%)	*
PowerShares FTSE RAFI Consumer Goods	$4.6 million	0.34	(7.6%)	NR
Rydex S&P MidCap 400 Pure Value (AMEX: RFV)	$14.0 million	0.41	(15.2%)	****
WisdomTree Japan SmallCap Dividend (NYSE: DFJ)	$75.4 million	0.41	(18.4%)	**
First Trust Consumer Staples AlphaDEX	$2.6 million	0.42	NA	NR
SPDR S&P Retail  (AMEX: XRT)	$364.6 million	0.43	(19.7%)	*
Rydex S&P 500 Pure Value  (AMEX: RPV)	$27.5 million	0.46	(13.9%)	NR

Sources: Yahoo! Finance. CAPS ratings courtesy of Motley Fool CAPS. One-Year Return is trailing net asset value (NAV) return through 3/14/08, except DFJ, which is reported through 3/13/08, courtesy of Morningstar. NA = not available. NR = not rated.

Tread carefully here, Fools; while the market offers many exchange-traded funds, few have a long history. While only two of these ETFs don't have a one-year performance record, none has a three-year record -- arguably an important milestone -- so only time will tell whether they can build solid track records over longer time periods. Remember, too, that ETFs follow their respective indexes. In a dropping market like we have, the above one-year performances are not too surprising

A strategy that pays dividends
It shouldn't be surprising to find homebuilders populating this list. With investors also disliking them -- as evidenced by their low CAPS ratings -- it highlights that sometimes cheap stocks are cheap for a reason. Similarly, with our economy apparently high-stepping into a recession, funds that seek to match performance aligned with consumer spending -- retail stocks and consumer goods, for example -- also have their place on this low-priced list.

Yet one fund in the group holds the promise of being able to weather an economic downturn better than most. The WisdomTree Japan SmallCap Dividend ETF, despite being heavily invested in cyclical consumer stocks and heavy industries, seeks out small-cap companies that pay dividends. According to famed economist and author Jeremy Siegel, fundamentally weighted indexes, such as the one followed by this ETF, as opposed to market-cap weighted ones, hold up better in a bear market and do nearly as well in a bull market.

For investors, it's also a play on the U.S. dollar that the Federal Reserve has considerably weakened with its monetary policies. That makes the Japanese yen look stronger even if a slowing U.S. economy serves as a drag on international markets.

That creates bargains for CAPS All-Stars like hey4ndr3w with a 98.13 player rating, who sees the sagging Nikkei index being weighted down by the strong yen in this pitch from the beginning of the year.

Japanese stocks are historically cheap right now. In 2007, the [Nikkei] turned in its first yearly loss since 2002, at the same time their neighbors in Asia were posting double digit gains ... Much of the decline in the [Nikkei] can be attributed to the recent rise of the yen, which sucks the value of earnings from foreign markets when they're converted to the foreign market's currency ... Institutional investors are sniffing around, looking for new places to park cash. WSJ reports that the Qatar Investment Authority, with over $60-billion under management, is looking to buy Japanese shares, as is the China investment Corp... A rising tide of investment dollars will float a lot of keels.

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 CAPS, let us know whether you think these ETFs' low price-to-sales ratios will contribute to them turning around, or whether it's time for a different metric.