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 $572 billion of the more than $1 trillion in stock index funds as of Nov. 30, 2007.

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 focused investments, it also concentrates the risks of specialization, tilting a portfolio away from the diversification that makes index investing attractive.

Small-cap stocks and funds had been doing quite well for the past few years, but that began to change in 2007, when large caps started doing better -- or perhaps less worse -- than their smaller brethren. As Fool analyst Dan Caplinger recently noted: "Over the past year, large-cap growth funds have risen 8.25%, while large-cap value funds fell nearly 2%. With smaller stocks, the disparity was even more dramatic, with small-cap value funds down more than 11%, while small-cap growth funds eked out a 2% gain."

Below are the small-cap ETFs with the best three-year performance, sorted by their returns during the past 12 months.

ETF

Three-Year Return

One-Year Return

CAPS Rating

iShares Russell 2000 Value Index (NYSE: IWN)

13.17%

(18.68%)

****

Vanguard Small-Cap Value ETF (AMEX: VBR)

14.92%

(14.67%)

****

iShares Morningstar Small Core Index (NYSE: JKJ)

16.30%

(14.63%)

*****

iShares Russell 2000 Index (NYSE: IWM)

19.23%

(10.54%)

**

iShares S&P Small-Cap 600 Index (NYSE: IJR)

20.24%

(9.16%)

***

Vanguard Small-Cap ETF (AMEX: VB)

22.90%

(7.93%)

****

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

Tread carefully here, Fools. While the market offers many ETFs, few have a long history. While all of the funds listed above have a three-year performance standard -- an arguably important milestone -- only time will tell whether they can build similarly solid track records over five- and 10-year periods.

Climbing a wall of opportunity
In their book Investing in Small-Cap Stocks, authors Christopher Graja and Elizabeth Ungar discuss the small-cap cycle, and how small-cap stocks continually go through periods of dominance and underperformance. To measure our current position in the cycle, Graja and Ungar compare the price-to-earnings ratio of the T. Rowe Price New Horizons Fund (FUND: PRNHX) to that of the S&P 500.

If the two P/E ratios were about equal, small caps would be oversold, and we could expect a period of overperformance. If the New Horizons Fund posted about twice the index's P/E, it might signal an overheated small-cap market, and we could anticipate a fall. Today, New Horizons' P/E is 21.2, while the S&P is 14.3; not a double, to be sure, but extended far enough that we might expect continued underperformance for a while.

CAPS investor lsszfr likes the value side of the small-cap universe, noting that over the long term, small caps tend to outperform the market. That's why he sees the better-performing Russell 2000 Value Index as a winner and a proxy for those who wish to avoid digging into individual stocks.

Small caps are down, but long term should out-perform the S&P. Nice index to save you from hours of digging into individual company financials.

Or, as CAPS All-Star Gtrinvestor, with a 99.90 player rating, noted last summer, the market never seems to have beaten this ETF yet: "I can't find a chart where the S&P beats IWN."

Although large caps might be on the ascendant now, for long-term investors wanting to beat the market -- although perhaps not generate a positive return for the near future -- focusing on the value component of the small-cap universe might be the right investment.

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.

Fool contributor Rich Duprey does not have a financial position in any of the funds mentioned in this article. Check out Rich's holdings to see for yourself. The Motley Fool's disclosure policy is both a dessert topping and a floor cleaner.