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 $596 billion of the more than $1 trillion in stock index funds as of April 30 -- a 28% increase over last year, and up $25 billion from March.

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.

There is an upside, though. As we've explained, "ETF investors have less exposure to capital gains taxes than mutual fund shareholders. That's because fund managers frequently buy and sell the fund's holdings -- and ask investors to pick up the tab. ETFs occasionally shift shares, too, although much less than most mutual funds." According to the American Association of Individual Investors, stock mutual funds typically have a turnover ratio around 80%, and bond funds are closer to 100%. That latter figure means the dollar value of fund purchases or sales equaled the dollar value of total fund assets during the year. The iShares Lehman Aggregate Bond (AMEX: AGG) ETF, for example, has a turnover ratio of 458% -- in other words, it turns over its portfolio almost five times a year.

So we're going to focus on ETFs that over the past three years have combined the best performances with the lowest turnover in their portfolios. We'll then filter that information through the collective intelligence of the 110,000 professional and novice investors at Motley Fool CAPS, to see which funds our participants consider the market's best.

ETF	Net Assets	Turnover Ratio	3-Year Return	CAPS Rating
DIAMONDS Trust	$8.85 billion	1%	16.9%	***
SPDR DJ Wilshire Total Market	$138 million	2%	12.8%	NR
iShares MSCI Japan Index	$8.29 billion	3%	25.1%	****
iShares S&P/TOPIX 150 Index	$216.3 million	3%	29.4%	**
SPDR Trust (AMEX: SPY)	$77.06 billion	3%	11.7%	NR

Source: The Wall Street Journal and Yahoo! Finance. CAPS Ratings courtesy of Motley Fool CAPS. NR = not rated.

Tread carefully with ETFs, Fools; while the market offers many exchange-traded funds, few have a long history. We only screened for ETFs with a three-year performance record this week, but only time will tell whether they can continue building a solid track record over longer time periods.

A strategy that pays dividends
SPDR Trust, also known as Spiders, is the low-cost granddaddy of ETFs. It's also often a good way to get broad market exposure without paying hefty expenses. Mimicking the composition and performance of the S&P 500 index, SPDRs offers easy access to the 500 largest companies in the market. An investment in SPDR gives you ownership of AT&T (NYSE: T), ExxonMobil (NYSE: XOM), and Microsoft (Nasdaq: MSFT), and that's just the beginning.

That same diversification in stocks also gives you diversity in sectors as well. While financial services comprise 17% of the ETF, energy is 14%, industrial materials 13%, and health care is 11% of the total.

Among others, you'll gain exposure to the savvy, green-eyeshade types at JPMorgan Chase (NYSE: JPM), which CAPS investor davenerven considers to be money in the bank when compared to its rivals:

[JPMorgan Chase] is USA's largest bank, with diversified and profitable operations worldwide. It has a history of competence and savvy, and compared to foreign banks, it is undervalued. So either we are questioning the competence of [JPMorgan], or we are panicking. Do we think [JPMorgan] is inferior to, say, Barclays or Fortis or Credit Agricole, etc, at doing deals and managing risk? Why did the Fed choose [JPMorgan] for the Bear Stearns deal? Why not choose Goldmans or Merrill or someone else? There is therefore an implicit understanding at the Fed that [JPMorgan] has more fortitude than other banks to survive and prosper in this current difficult climate.

Investing in SPDR also gives you the stability of consumer goods maker Proctor & Gamble (NYSE: PG). Just a few days ago, top-rated CAPS All-Star DemonDoug judged P&G a solid bet, considering the number of its products occupying his own medicine cabinet:

Yield 2.6%. Solid. Products from [Procter & Gamble] in my bathroom: Mach 3 razor, Crest toothpaste, Vicks vapo rub. I occasionally have pringles in my food closet, and duracell is my battery of choice. Things i don't have but you might are always, head and shoulders, pantene, oil of olay, tide, dawn, downey, pampers. This company has been around for 171 years. That means it didn't just survive the depression and 2 world wars, but also multiple depressions in the 1800s. I can't find exact numbers, but from the 10Q summary: "Our products are sold in more than 180 countries primarily through mass merchandisers, grocery stores, membership club stores and drug stores. We have also expanded our presence in "high frequency stores," the neighborhood stores which serve many consumers in developing markets." I believe at least 50% of all sales are outside the US and this number is likely higher. Expect [Procter & Gamble] to keep growing steadily over the next 10 years.

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.