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 $559 billion of the more than $1 trillion in stock index funds as of the end of February -- a 29% increase over last year, but down $9.4 billion from January, itself down from the prior month.

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

Small-cap stocks and funds had been doing quite well for the past few years, but that began to change in 2007, when large caps started doing better -- or perhaps less worse -- than their smaller brethren. As Fool analyst Dan Caplinger recently noted: "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 more than 11%, while small-cap growth funds eked out a 2% gain."

Below are the small-cap ETFs with the best one-year performance, but when you see the results below, you'll understand that "best" is a relative term. When we look back over their three-year return periods, we get a better idea of which ETFs have held up better over the long term and which are still new to the game.

We'll then combine this information with the views of the collective intelligence of the 100,000 professional and novice investors at Motley Fool CAPS, to see which funds our participants have rated as the best.

Tread carefully here, Fools. The market offers many ETFs, but few have a long history. Most of them have a three-year performance standard -- an arguably important performance milestone -- and only time will tell whether they can build similarly solid track records over five- and 10-year periods.

A strategy that pays dividends
In their book Investing in Small-Cap Stocks, authors Christopher Graja and Elizabeth Ungar discuss the small-cap cycle and explain how small-cap stocks continually go through periods of dominance and underperformance. To measure our current position in the cycle, Graja and Ungar compare the price-to-earnings ratio of the T. Rowe Price New Horizons Fund (FUND: PRNHX) to that of the S&P 500.

If the two price-to-earnings ratios were about equal, small caps would be oversold, and we could expect a period of outperformance. If the New Horizons Fund posted about twice the index's P/E, it might signal an overheated small-cap market, and we could anticipate a fall. Today, New Horizons' P/E is 16, while the S&P is 13.4 -- not equal, to be sure, yet far enough apart that we might continue to expect underperformance for a while.

CAPS investor costanostra notes that although small caps get hit first in a downturn such as we've been experiencing, they are the first to recover as well. That's why he sees the better-performing Russell 2000 Index as a winner and a proxy for those who wish to avoid digging into individual stocks:

The Russell 2000 Index were the first to sell off and will be the first to recover from the bear market. IWM is a great way to play the index without having the risk to individual companies. Small Caps is where you will find future growth.

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, you can let us know whether you think these ETFs will continue to outperform, or whether it's time for new ones to top the lists.