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 $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.

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.