A "Short" Course on ETFs

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

A basket of stocks
That could explain why exchange-traded funds are now so popular. ETFs, originally modeled after index funds, are funds that trade like stocks. The first batch of ETFs, known as SPDRs (pronounced "spiders"), offered even lower expense ratios than many index funds, along with some additional tax efficiency. The ability to trade ETFs like stocks added to their popularity, although Fools should note that increased taxes and trading costs can erase any benefits from buying and holding an ETF.

As ETFs proliferated, they gradually narrowed their contents, from broad indexes to 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, making it more risky than the more diversified S&P index.

Some of the best returns realized in ETFs this year have come from funds that utilized shorting strategies. The best return was realized by UltraShort Semiconductor ProShares, which has nearly doubled in value year to date. It aims to return twice the inverse of the daily performance of the Dow Jones U.S. Semiconductor Index.

Not surprisingly, that index comprises some of the biggest names in the semiconductor universe, names that haven't performed particularly well in this climate. Below are the top 10 components of the index, including their weighting, and how they've performed so far this year. We'll also look at what the Motley Fool CAPS investing community database thinks of these stocks.

Source: wsj.com; Yahoo! Finance. YTD = year to date.

While taking the short route has led to some eye-popping returns at a time when all else seems to be crashing, investors would be wise to watch out for a large tax bill that might come due as a result of capital gains distributions.

Seeing stars
Even with these individual stocks down by large amounts, investors remain fairly confident that they will be long-term winners -- almost all of the stocks earn a three-star or better rating from CAPS members. However, one didn't. Let's take a look at First Solar.

With more than three-quarters of the members ranking First Solar calling it to outperform the market, there is also concern that there may be good reason the industry recently burst into flames. For example, at least one analyst thinks the top solar play may have trouble moving more of its inventory next year, and top-rated CAPS member srk85 thinks valuations remain at lofty levels. "While there has already been a big correction in the price, a few more years of growth at the expected levels are needed to justify current levels."

Looking elsewhere, CAPS member gone2017 finds the financial strength of Intel to be a core reason for it being able to withstand the economic recession:

Right now, I'm into fortress balance sheets that make companies immune from credit market problems. The yield is also nice. Any time you can get a manufacturer to put a sticker with your name on it on THEIR product - because they want everyone to know they only use the best components - your brand has arrived, your moat is very wide, and you are a world dominating franchise.

A basket of opinions
Although ETFs have been around since the 1990s, investors might want to be cautious with any ETF that doesn't have a long track record. It pays to start your own 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. Head over to CAPS today and share your thoughts with other investor-analysts on whether you think these stocks make the grade.

On Jan. 12, 2009, Fool co-founder David Gardner, Jeff Fischer, and their Motley Fool Pro team will accept new subscribers to their real-money portfolio service. Motley Fool Pro is investing $1 million of the Fool's own money in long and short positions in a range of securities, including common stocks, put and call options, and exchange-traded funds (ETFs). They also incorporate proprietary CAPS "community intelligence" data into their research. To learn more about Motley Fool Pro and to receive a private invitation to join, simply enter your email address in the box below.