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 also a $39 billion drop from December.

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 and tilts 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 483% -- 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 while the lowest turnover in their portfolios. We'll then combine that information with the views of the collective intelligence of the 95,000 professional and novice investors at Motley Fool CAPS, to see which funds our participants have rated as the best.

Sources: The Wall Street Journal and Yahoo! Finance. CAPS ratings courtesy of Motley Fool CAPS.

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

A strategy that pays dividends
The BLDRS Emerging Markets 50 ADR Index Fund tracks the Bank of New York Emerging Markets 50 ADR Index, a capitalization-weighted index designed to track the performance of a basket of emerging-market-based depositary receipts. Brazil, China, and South Korea make up more than half of the fund, respectively, with more emphasis flowing to the South American country, which has continued grow over the past year.

It's the diversification across 50 companies in emerging markets that has CAPS player HerM0ney seeing this ETF as a continuing engine of growth.

I own this ETF. A buy and hold call for me. [A] great ETF that has [outperformed] the major US indices since [its] inception. I believe the investment [scene] will no longer be dominated by the US. The trading and [business] as we know it has evolved into a dynamic global market place. This ETF is not bound by countries or sector and I believe has [a] very low expense ratio. It has 50 top performing companies from different sectors and various [markets] including the BRICs. I believe emerging markets provide great growth for the future and can be profitable. I [complement] this with GWL [SPDR S & P World ex-US] for more [balanced] international exposure.

With 98% of the CAPS investors who have weighed in on BLDRS thinking it will outperform the market, it's safe to say that HerM0ney's CAPS peers tend to agree with this assessment.

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.