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.

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 threatens to tilt a portfolio away from the diversification that makes index investing attractive.

Volatility Rocks
Today, we're looking at the exchange-traded funds that exhibit the lowest beta. As a measurement of risk, beta is useful, although not comprehensive. For one thing, it primarily looks at only one specific criterion -- trading volatility -- but ignores other types of risk, like size and event-specific items. Furthermore, ETFs that might be expected to fall less in declining markets will also rise less in surging markets. Still, in current conditions, ETFs that exhibit low betas might offer investors some peace of mind and make for an attractive investment.

Sources: Yahoo! Finance, The Wall Street Journal. CAPS ratings courtesy of Motley Fool CAPS. A beta of less than 1 indicates that the stock's price is more stable than the market (in general and over a long time period). A stock with a beta of more than 1 is more volatile than the market.

Tread carefully here, Fools. The market offers many ETFs and securities that look like funds but aren't -- such as exchange-traded notes. Moreover, few have a one-year performance standard let alone three years -- an arguably important milestone -- and only time will tell whether any of these can build solid track records over longer time periods.

A world of opportunity
The beta of an ETF, of course, is a function of the stocks that the fund holds. Among the top holdings of the top-rated iShares S&P Global Healthcare fund are pharmaceutical companies including Johnson & Johnson (NYSE:JNJ), Novartis (NYSE:NVS), and GlaxoSmithKline (NYSE:GSK), which have an average beta of 0.38. On the high side of the beta curve has been Merck (NYSE:MRK), with a 1.51 beta. Undoubtedly, the risks which the betas highlight are predicated not only on the blockbuster drugs the companies have on the market -- and the ones in their development pipeline -- but also the amount of research and development the pharmas perform to maximize that pipeline.

Over the past three years for which the betas of the ETFs were calculated, Merck has indeed been more volatile than the S&P 500, and mostly to the upside, while Pfizer (NYSE:PFE) and GSK have underperformed the market. Interestingly, Wyeth (NYSE:WYE) has a similar return to the market over that time frame.

Investors are still bullish about Pfizer's future performance despite its lackluster recent past. As CAPS player Valuevest notes, the combination of low price, lots of cash, and a hefty dividend make it an attractive investment:

Curious that the maker of Viagra cannot get its stock prices to rise despite buyback and insider buying and a hefty 6.5% dividend. I am no better than Warren [Buffett] so I don't feel bad proclaiming my ignorance as to the pipeline. … I do understand that this stock is cheap with cash on hand, less than 10 forward P/E and nice dividend. So that is why I am a buyer. Besides, it is a magic formula large cap stock.

On the other hand, not everyone is so sure about Merck, despite the Vioxx settlement. CAPS investors like Meripendium believe that its other recent defeats spell longer-term troubles: "After major losses [from] Zocor generic Merck has taken [its] time coming out about whether Vytorin works any better than the less expensive generic Zocor, but amid possible delayed study results the proof may be in the pudding where Merck slashed the 2008 revenue forecast for Vytorin by 700 Million. Add this to the recent rejection of two different Merck drugs (a [cholesterol] med and an allergy combo) by the FDA and the future doesn't look so bright."

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.