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 $596 billion of the more than $1 trillion in stock index funds as of April 30 -- a 28% increase over last year, and up $25 billion from March.

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, by 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 is a list of the small-cap ETFs with the best one-year performance, but when you see the results, you'll understand that "best" is a relative term. When we look back over their three-year returns, we get a better idea of which ETFs have held up better over the long term and which are still new to the game.

We'll then combine this information with the views of the collective intelligence of the 110,000 professional and novice investors at Motley Fool CAPS, to see which funds our participants have rated as the best.

Source: Yahoo! Finance. CAPS ratings courtesy of Motley Fool CAPS. NA = not available.

Tread carefully with ETFs, Fools: Although the market offers many exchange-traded funds, few have as long of a history as these do. Indeed, not many even have a three-year return history, arguably a key milestone. Only time will tell whether they can continue building a solid track record over longer periods.

A strategy that pays dividends
The PowerShares Clean Energy ETF consists of alternative-energy companies that research and produce solar and wind power, ethanol, fuel cells, and other renewable sources of energy. It's not surprising that along with much of the small-cap universe, the stocks that make up the fund -- even though they've been some of the hottest companies around -- have this year cooled off.

The fund, which is a Motley Fool Rule Breakers recommendation, has some of the top names in alternative energy in its portfolio: Evergreen Solar (NASDAQ:ESLR), Suntech Power (NYSE:STP), Energy Conversion Devices (NASDAQ:ENER), and ReneSola (NYSE:SOL).

With oil prices remaining at elevated levels, the impetus driving many of the alternative-energy plays remains in force. Rather than having to pick and choose among the players for which company or technology will ultimately succeed, the beauty of the ETF is that it gives you broad diversification over the entire sector.

You needn't ponder whether First Solar's (NASDAQ:FSLR) polysilicon-free panels will be the preferred solar choice -- though recent quarterly earnings suggest that it remains on fire -- or whether American Superconductor (NASDAQ:AMSC) is as controversial as critics contend. Even if some companies burn out as a result of exaggerated claims, your exposure to them has been minimized.

Yet if one of the technologies proves to be a winner, many in the field will benefit, as will the ETF. That's why some top investors think the alt-energy field is ripe for picking. CAPS All-Star member tuffsledding writes:

T Boone Pickens means business! Wind and Solar are the future, ethanol is dead. Fasten your seatbelts, this may be a volatile ride, but I think their major holdings are no longer overvalued, given the current conditions.

A basket of opinions
Although ETFs have been around since the 1990s, investors should exercise caution with any ETF lacking a long track record. It pays to start your research on these stocks on Motley Fool CAPS. Read a company's financial reports, scrutinize key data and charts, and examine the comments your fellow investors have made -- all from a stock's CAPS page. Then weigh in with your own thoughts on which ETFs you think will continue to outperform, or whether it's time for new ones to top the lists.