Seven Great ETFs

But it occurred to us that by devoting so much attention to active managers we were ignoring those investors who preferred index funds, especially exchange-traded funds. And as much as those 35 funds had a banner year in 2006, so, too, did the ETF industry. As of Dec. 29, there were 359 ETFs holding $417 billion in their coffers. A year before that date there were just 201 ETFs with $296 billion. Of the new offerings, 112 were specialty and sector funds, products that pushed the envelope on what has traditionally been an index fund alternative.

That means index investors don't need to settle for plain vanilla market returns any more. Granted, the most popular ETFs are still the low-cost, broad-based ones that track established indexes like the Standard & Poor's 500. But a fresh generation of newfangled ETFs may also give investors some extra returns on the margins. Now we have to couch that statement. After all, if you only save for retirement in a 401(k) you won't be seeing ETFs as one of your investment options. That's because you can't dollar cost average into these funds without incurring a trading commission every time you buy one. However, if you also save in a brokerage account via lump sum contributions or use a financial planner, well, you could consider the ETFs on this list as excellent complements to active managers.

Before we get to those funds, though, one reminder about ETFs. You have to pay close attention to the underlying benchmark. For example, the top 10 holdings in the S&P 500 and the Russell 3000 may look the same, but as you drill down, the Russell index has more exposure to small-cap and midcap stocks. That helps performance when those shares are in favor. Indeed, the average annual return of the Russell 3000 over the last three years has outpaced the S&P 500 by a full percentage point.

We mixed a little performance evaluation with expert advice to find ETFs in the same seven categories SmartMoney magazine used in its mutual fund wrap-up. Here are our favorites.

Obviously, you could anchor that duo with a broad-based product like SPDRs (SPY), which track the S&P 500. But a more intriguing choice is the Rydex S&P Equal Weight ETF (RSP). This fund weights its portfolio in equal amounts vs. rewarding larger positions to companies with the biggest market capitalizations. This difference means smaller members of the S&P 500 can influence returns just as much as its largest constituents like General Electric (GE), Microsoft (MSFT) or Bank of America (BAC). And that adds up: This ETF has returned 12.5% over the last three years, two-and-a-half percentage points better than the S&P 500 and the T. Rowe Price Growth fund. (Linehan beat that mark by three quarters of a point.) "I think it's a winner," says Rob Lutts, chief investment officer of Cabot Money Management.

We think growth-stock funds — Smith's included — will have a big 2007 after a few years of the doldrums. If you want exposure to large-cap growth stocks consider the iShares Russell 1000 Growth ETF (IWF). It owns about 680 of the largest growth stocks on the market, including Johnson & Johnson (JNJ), General Electric and Intel (INTC). While you won't get Smith's stock-picking prowess, you will get a fund that has many of the same holdings at a fraction of the cost. The iShares offering charges an expense ratio of 0.20%, vs. 0.72% for T. Rowe Price Growth.

The Vanguard Total Stock Market ETF (VTI) isn't categorized as multicap. But we beg to differ. It owns a whopping 3,700 stocks, split between large-company shares (72% of assets), midsize (19%) and small (8%). You'll find a portfolio mixed with big names like Exxon Mobil (XOM) and unknowns like Watsco (WSO) and Imation (IMN). This ETF's dirt cheap expense ratio of 0.07% makes it an excellent portfolio cornerstone. So, too, does its returns: Over the last three years it's had an average annual return of 11%, a full percentage point ahead of the S&P 500.

While many portfolios have been recalibrated to include international funds, some of you may still be just getting your feet wet. If you have ever sat down with a financial planner they may tell you about a portfolio design strategy called "core and explore." In short, the core of your portfolio is in conservative investments, while a smaller portion is earmarked for something more aggressive. You can do that with your international holdings, too, an easy way to test the waters before jumping in head first. Polaris Global Value and Dodge & Cox International would be the "explore" part, while the core could be the iShares MSCI EAFE (EFA).

This fund saw tens of billions of dollars flow into it in 2006, a tip-of-the-hat to stellar international returns that have outpaced the U.S. Indeed, this ETF posted an average annual return of 17.6% over the last three years compared to 10.5% for the S&P 500. It owns 800 companies spread out over Europe, the U.K. and Japan, each with an average market capitalization of $33 billion. Top holdings include BP (BP), HSBC Holdings (HBC), Toyota (TM) and Total (TOT). The only drawback is that it has little exposure to emerging markets, a niche that has provided some decent returns in the past. If you don't mind the risk, says our expert, pick up the Vanguard Emerging Markets ETF (VWO). It owns companies in South Korea, Taiwan, Russia and South Africa. "[The EAFE ETF] really doesn't have a lot of exposure to emerging markets," says Paul Ohanian, vice president of financial planning firm WealthTrust-Arizona. "I would take a little allocation out of international and move it into VWO." Sounds like a smart move to us, too.