2008 Year-End ETF Review

2008 may not be the worst year on record for the Dow -- barring a late-day collapse, we'll still finish well ahead of 1931, in which the Dow lost more than half its value. Yet, that perspective is cold comfort for investors who struggled to find assets with positive returns throughout the year.

Partying with the bear
A niche group of bear market ETFs were one of the few bright lights in the gloom. UltraShort QQQ ProShares (NYSE: QID  ) , ran up a return of nearly 90%. Of course, maintaining those returns for 2009 would require another big drop in the market, and in any event, these funds are extremely volatile.

Now that the markets seem to have approached some sort of bottom, there may be buying opportunities in more conventional ETFs. However, it is well worth looking at some of the problems ETFs faced in 2008 before considering ETF investment ideas for the coming year.

An end to the trend?
There were few investment strategies that worked in 2008, and around 50 ETFs folded, marking a significant change for an industry that in the past three years has churned out new funds left and right. Still, more than 200 funds came to market in 2008, resulting in a net addition to existing ETFs. That might seem like good news, but more fund options means investors must spend more time and effort figuring out which fund is best for them.

Another issue with new niche ETFs is that some of these funds never gather enough assets to make them viable, and they may shut in the future, causing headaches for investors. With any fund, but especially the smaller ones, it is important to look at their trading volume to ensure that there are enough shares being traded in the market so that the impact of trading costs and wide spreads do not eat into your investment returns.

The approach an ETF uses to track its index can also play a role in how well the fund handles market turbulence. Some funds follow a replication approach, which means they own every stock in the index. Full replication generally incurs far more trading costs than other approaches. Other funds synthetically replicate their index using derivatives or a sampling technique.

Another point to consider is that indexes that are narrowly defined and made up of only a few securities, or have a few stocks which dominate them, can be difficult to track when there are rapid or sudden changes in market prices and volatility.

Looking ahead for opportunities
Although we're now officially in a recession, there is some hope that a rebound might be in the works. Most of the industrialized world has not been as quick or as aggressive as the U.S. in using fiscal and monetary stimulus to jumpstart their economies. As a result, Europe and Japan may lag the U.S. in emerging from recession.

With an additional stimulus package expected for the U.S. by the new administration, combined with low interest rates and steep declines in energy prices, there could be a solid foundation for a strong upward trend in U.S. stocks in the coming months.

Infrastructure and alternative energy have been widely touted as sectors that will benefit from an Obama administration. Companies like Corning (NYSE: GLW  ) and First Solar (Nasdaq: FSLR  ) may look more attractive in 2009, whereas ETFs focusing on solar and wind energy may reverse their huge declines from the last half of 2008.

Investors should not ignore the U.S. bond market, as fear has pushed corporate debt to near bankruptcy-level risk premiums. When the market begins to revert to more normal levels of risk, more credit-worthy companies such as Johnson & Johnson (NYSE: JNJ  ) , Microsoft (Nasdaq: MSFT  ) , and Pfizer (NYSE: PFE  ) are likely to see their bonds rise. At the same time, bonds offer more security than stocks, and these days, that is widely viewed as a real plus. An investment in a high-grade corporate bond fund like the iShares iBoxx InvesTop Investment Grade Corporate Bond Fund (LQD) would be one way to play this asset class. For those willing to take this strategy out on the risk curve, the iShares iBoxx High Yield Corporate Bond Fund (HYG) is a riskier but potentially higher return option.

Don't count out the rest of the world and hedge your bets by making an allocation to investment outside the U.S. Most of the world has seen their markets been beaten down by the global recession, but despite the risks involved, there are still arguments for diversifying your portfolio outside of the U.S. The iShares S&P Global Infrastructure fund (NYSE: IGF  ) is one ETF to consider for this approach. Many developing nations are expected to grow faster than the U.S., and some may rebound quicker, providing an opportunity to make positive returns ahead of the U.S. markets.

ETFs have many virtues, but some of their vices were revealed as the dismal 2008 market stressed funds. With fear running rampant in the market and dark clouds on the horizon, many investors have simply given up on investing. That may prevent further losses, but the depressed levels of the markets may also present a real opportunity for longer-term investors.

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Fool contributor Zoe Van Schyndel now lives in the Seattle area, where she enjoys the coffee and natural wonders. She does not own any of the funds or securities mentioned in this article. Pfizer and Johnson & Johnson are Motley Fool Income Investor selections. Pfizer and Microsoft are Motley Fool Inside Value recommendations. The Fool owns shares of Pfizer. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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  • Report this Comment On January 05, 2009, at 3:38 AM, kayakmastr wrote:

    Recommending ETFs for superficial reasons is fine and has some merit, but a more in-depth analysis would be appreciated. For example, what are the holdings. HYG was mentioned, but there are other similar high yield bond funds, of 2 or 3, which would be a better choice and why.

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