ETFs for Tomorrow

Investing in index funds can be all the Foolish strategy you need to build a financially rewarding portfolio. You get instant, low-cost diversification across a variety of industries, and you never have to worry about timing the market.

Making automatic contributions into an index fund gives an average investor all the benefits of dollar-cost averaging, making it easy to save regularly for the future. Warren Buffett once noted that his favorite time to sell is "never," and in that respect, index funds let you invest just like the Oracle of Omaha does.

That could explain why exchange-traded funds are now so popular. According to the Investment Company Institute, ETF assets made up more than $507 billion of the more than $1 trillion in stock index funds as of August.

A basket of stocks
ETFs, originally modeled after index funds, are mutual funds that trade like stocks. The first batch of ETFs, known as SPDRs ("spiders"), offered even lower expense ratios than many index funds, along with some additional tax efficiency. The ability to trade ETFs like stocks added to their popularity, although Fools should note that increased taxes and trading costs can erase any benefits from buying and holding an ETF.

As ETFs proliferated, they gradually narrowed their focus, moving from broad indexes to specialized slices of the market. That's been a boon to investors seeking to home in on certain areas of the market by buying a basket of related stocks. But it also concentrates the risk that accompanies such specialization, tilting a portfolio away from the diversification that makes index investing attractive.

Today, we're looking at the exchange-traded funds whose component stocks have shown the highest earnings growth over the past 12 months. Companies that are collectively growing their profits at a rate higher than those of their peers might make an exchange-traded fund composed of such stocks an attractive investment itself.

While there are many exchange-traded funds to choose from, few have a long history. For example, only one of these ETFs has a one-year return rating, let alone a three-year one -- an arguably important performance milestone. Of course, even venerable mutual funds had to start sometime, so only time will tell whether these ETFs can build as solid a track record over five-and 10-year time periods. Until then, however, investors would be wise to use caution.

An ETF of good hope
The longest-running fund in this group specializes in stocks trading on the Johannesburg exchange in South Africa. More than 20% of the value of the iShares MSCI South Africa Index is in just two stocks -- Motley Fool Global Gains recommendation Sasol (NYSE:SSL) and MTN Group. While that concentrated portfolio does entail risk (the fund's net asset value suffered a big pullback in August), the companies making up the index have smartly used the country's resources. Moreover, a surging middle class -- increasing 30% in size in just two years and accounting for 28% of the country's buying power, according to The Economist -- points to the potential for the economy to grow further.

CAPS player pakaal notes that the international community has been investing in the natural resources of the country lately, and with the turmoil that neighboring nations represent, a politically volatile yet economically stable South Africa is positioned to capture further foreign investment:

For me this index fund tips in the direction of high risk-high gain. While South Africa (SA) is a very volatile country and a lot of negatives (high murder rate, rising reports of governmental corruption among other things), it is also recognized as the only country in the region that is stable, has something of a positive influence over its neighbors, and has a developed communications and tech infrastructure. China and Australia have been investing heavily in SA in the past couple of years, specifically in mining and metals, which got me thinking about SA's long-term viability as a country (sorry to put it so bluntly, but there it is). Zimbabwe is going into meltdown mode, Namibia is not doing so well, and Botswana is turning itself into one giant safari attraction (hey, more power to them, it's working well so far). Mozambique is faring better, but is still struggling to find its place in the African political world. These countries rely on the stability of SA to a great extent (particularly Zimbabwe, whose people are crossing the border in droves to the relatively well-off SA).

All in all I think South Africa is going to be a focus of investment attention for the next five years at least. And we're at the bottom of their growth curb.

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 on whether you think these ETFs will continue to outperform or whether it's time for new ones to ascend to the top of the lists.