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 $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. 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.

Today, we're looking at ETFs with portfolios that have the lowest portfolio price-to-sales ratio. Although the ratio has its limitations, famed analyst James O'Shaughnessy, author of What Works on Wall Street, believes that a P/S ratio of less than 1.5 indicates a potential bargain in the market. An ETF composed of such stocks might itself represent a bargain.

We'll combine that information with the views of the collective intelligence of the 105,000 professional and novice investors at Motley Fool CAPS, to see which funds our participants have rated as the best.

ETF	Portfolio P/S Ratio	1-Year Return	CAPS Rating (Out of 5)
Rydex S&P SmallCap 600 Pure Value	0.28	(27.9%)	**
iShares Dow Jones US Home Construction	0.32	(53.4%)	*
PowerShares FTSE RAFI Consumer Goods	0.33	(15.8%)	NR
SPDR S&P Homebuilders   (AMEX: XHB)	0.35	(43.7%)	*
PowerShares WilderHill Prog Energy (AMEX: PUW)	0.38	3.8%	****
Rydex S&P Midcap 400 Pure Value	0.40	(15.7%)	**
WisdomTree Japan SmallCap Dividend	0.40	(11.1%)	**
PowerShares Dynamic Healthcare Services	0.42	(17.5%)	NR

Source: Yahoo! Finance. CAPS Ratings courtesy of Motley Fool CAPS. ETFs in existence less than a year were ignored.

Tread carefully here, Fools; the market offers many exchange-traded funds and securities that look like funds but aren't -- such as exchange traded notes. Moreover, not all have a one-year performance standard, let alone three years -- an arguably important milestone -- and only time will tell whether any of these can build similarly solid track records over longer time periods.

It's easy to see why the homebuilder ETFs have such a low P/S ratio -- sales at companies such as KB Home (NYSE: KBH) have fallen drastically over the past year. That explains the low CAPS rating, too. But why does that four-star energy ETF have such a low P/S? Let's dig in a bit further.

A world of opportunity
We're progressing into a period where technologies will provide for mass production of clean energy. It's coming, but it's not here yet. In the meantime, there are companies working toward creating "cleaner" energy, and their technologies will be the early adoptees in the interim.

The PowerShares Progressive Energy ETF invests in companies that are improving the use of fossil fuels. Chesapeake Energy (NYSE: CHK), for example, makes up about 3.4% of the ETF's assets. So we're not talking necessarily about green technology, just greener. You'll also find amongst its holdings Fuel Tech (Nasdaq: FTEK), which optimizes combustion systems in utility, industrial, and municipal solid-waste applications, and USEC (NYSE: USU), which sells low-enriched uranium for commercial nuclear power plants.

As CAPS All-Star KatWoman50 explains, Progressive Energy points to where we want to be. It is, this player says, an "ETF investing in technology companies focusing on improving fossil fuel consumption and 'bridge' technologies to get us from reliance on oil to alternative fuels."

Another CAPS investor, sillydook, made similar points last year:

This ETF includes companies which should perform strongly as we transition from a world that runs on petroleum to a world that runs on alternative energy sources. The particular emphasis is on companies that extend or improve fossil fuels, although it includes other "bridge" technologies as well. USEC (USU), which supplies uranium to nuclear power plants, is one of the top holdings. The market cap and style leans towards small cap growth. On the whole, I prefer this ETF to [the PowerShares Clean Energy Portfolio (PBW)] because I think the holdings here are stronger than PBW's holdings.

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 will continue to outperform, or whether it's time for new ones to top the lists.