ETFs for Tomorrow

Investing in index funds can be a Foolish strategy so good that an investor wouldn't have to go beyond them to build a financially rewarding portfolio. You get instant diversification across a broad cross-section of industries, the ability to stop worrying about timing the market, and low costs.

Putting an investment program of automatic contributions into an index fund gives Investor Jane the benefits of dollar-cost averaging and saving regularly for the future. Warren Buffett once noted that his favorite time to sell was "never," and investing in index funds allows you to be just like the Oracle of Omaha.

That could explain why exchange-traded funds have become so popular. According to the Investment Company Institute, ETFs assets totaled more than $507 billion of the $1 trillion of equity held in index funds as of August.

A basket of stocks
ETFs, originally modeled after index funds, are mutual funds that trade like stocks. The so-called ETF "Spiders" offered potentially even lower expense ratios than index funds, along with some additional tax efficiency. That you could trade ETFs like stocks only added to their popularity, though increased tax and trading costs can easily erase any benefits.

Yet as ETFs proliferated, the ability to focus on more specialized areas of the market became possible. That's been a boon to investors seeking to home in on certain areas of the market and buy a basket of stocks there. But it also concentrates the risk that accompanies such specialization, and tilts a portfolio away from the broad diversification that makes index investing attractive.

Today we're looking at the largest exchange-traded funds and how they've performed year to date. We'll then combine that information with the collective intelligence of the professional and novice investors at Motley Fool CAPS to see which funds our participants have rated as the best.

While there are many exchange traded funds to choose from, it's only been recently that they've gained in popularity, so few have been around for any amount of time. The ones we're looking at today do have a bit of a track record to speak of, and a three-year return is arguably an important milestone for them. Only the Gold Shares ETF have not been around long enough to generate a three-year return. Of course, even venerable mutual funds had to start sometime, so only time will tell if these ETFs can build as solid a track record over five- and 10-year time periods.

An international flavor
It shouldn't come as a surprise that investors have a muted view of U.S. markets, while international economies generate fervor. Both the emerging markets ETFs and the more broad-based EAFE index have garnered top investor ratings. Along those lines, gold, as a hedge against a downturn in the U.S. economy, also receives high honors.

CAPS player mistrgolf offers a typical reason why the EAFE index is often included in many investors' portfolios, whether in the form of a mutual fund or ETF.

Has been a stellar performer for several years. Offers me overseas diversification and allows me to play into the U.S. economy softening faster than some other parts of the world. Quick way to buy a large basket [of] overseas blue-chips that can be hard to research and value.

It's that sort of reason that got the pundits at market research firm Netscribes to endorse the ETF back in March.

The iShares MSCI EAFE Index Fund, which enjoyed returns of 21.5% in the past ... year, [is] comprise[d] of 822 securities, making it a massive ETF, with 29.21% concentration in financial services sector, 20.36% in industrial goods and materials and 11.71% exposure to consumer discretionary among others.

The fund has such a broad base that the top ten securities make up ... merely 12% of the total share holding, with BP having the largest 1.53% share closely followed by HSBC Holdings and Toyota Motors holding 1.49% each. The fund typically has nearly twice as much exposure to financial stocks; because [the] UK, Australia, Hong Kong, and Singapore are full of major banking, real estate [and] other financial companies. Given a bright outlook for the participant nations and sectors, the fund appears to be a compelling idea.

A basket of opinions
Although ETFs have been around since the 1990s, investors might want to be cautious with any ETF that doesn't have a long track record. Give your opinion over at CAPS: Do you think these ETFs will continue to outperform? Or is it time for new ones to ascend to the top of the lists?