ETFs for Tomorrow

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

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

That could explain why exchange-traded funds have become so popular. According to the Investment Company Institute, ETF assets totaled more than $507 billion as of August 2007.

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

As ETFs proliferated, they began to diversify their focus from broad indexes to increasingly 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 broad diversification that makes index investing attractive.

Today, we're looking at the best-performing exchange-traded funds over the past three years. Then we'll combine that information with the views of the collective intelligence of the professional and novice investors at Motley Fool CAPS, to see which funds our participants have rated as the best.

While there are many exchange-traded funds to choose from, few have been around for any significant amount of time. The ones we're looking at today actually have a bit of a track record to speak of; a three-year return is arguably an important milestone for them. Of course, even venerable mutual funds had to start sometime. Only time will tell whether these ETFs can build such solid track records over five- and 10-year periods.

An international flavor
The top four economies in the Third World -- Brazil, Russia, India, and China -- comprise what are known as the BRIC countries. While China seems to get top billing these days, the first letter of that basic building block in a wall of investments stands for "Brazil," and it's proven to be a stellar investment over the long haul.

Earlier this year, top-rated All-Star alanknit highlighted a few of the reasons why the Brazilian economy should continue to outperform:

The B in the BRIC complex. Stronger currency growth via the US dollar. Great exposure to the economic engine of Brazil. Fabulous exposure to commodities. Booming global demand for exports. Great investment play on multiple global macro trends.

The pundits at market research firm Netscribes seem to agree that all the ducks are in a row in South America:

The robust growth has been reflected in the fund too, with one-year returns for 2006 of 45%. The country is rich in natural resources and has recently seen the demand for its commodities go up in the global market. With this scenario set to continue well into 2007, the commodity stocks [should] have a field day. President Lula has managed to bring a tight monetary policy and [has been] hugely successful in controlling inflation. This situation has led to a low interest rate regime encouraging banks to lend more to [corporations] and consumers, thus encouraging both the lenders and the spenders to actively take part in the growing economy. With 18% of assets under management invested in banks, this comes as a boon to the fund.

A basket of opinions
Although ETFs have been around since the 1990s, investors might want to be cautious with any ETF that lacks a long track record. Head over to CAPS to tell us 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.