The world was a different place over a decade ago when the world's first exchange traded fund, the S&P 500 SPDR, was listed. Most investors were broadly familiar with the S&P 500 index and most professionals thought that simply explaining the advantages and disadvantages of the ETF structure versus that of a comparable index mutual fund was sufficient "analysis" of for an ETF.

Perhaps because ETFs started out being compared to mutual funds, most analysts started evaluating them as mutual funds. Morningstar™, for example, the large mutual fund rating outfit, says in materials on its website, "The Morningstar Rating for exchange-traded funds uses the same methodology as the Morningstar Rating for [mutual] funds."

From the listing of the S&P 500 SPDR to today, however, the number of ETFs available to investors has exploded to a staggering array of over 400 choices and therein lies the problem. While the flexibility this expansion has brought is positive, it also complicates the selection process. How then should an investor determine which ETFs make the most sense for their portfolio?

Mutual Fund Performance

Mutual funds are typically evaluated based on past performance and fees. This is appropriate since most mutual funds are actively managed and, in a sense, by purchasing a mutual fund you are hiring the fund manager to invest on your behalf. In this case, it makes sense to evaluate the manager's past performance and assess the related service charges.

ETFs, however, are inherently different. There is no active manager deciding when to buy or sell certain stocks, when to enter or exit a sector, nor is there anything inherently positive or negative about any fo the indexes ETFs track. Rather, the investment merit of an ETF is determined by two factors that are in a state of constant change: 1) market conditions and 2) the fundamentals of the underlying stocks which comprise the fund.

Who is not aware that, over the past five years, Technology stocks in general were a bad investment? What moderately-informed investor doesn't already know that over the same time period small cap stocks outpaced large cap stocks? If a mutual fund manager failed to foresee these changes, you'd have a valid complaint that he was probably not earning his keep. An ETF tracking an index of Tech or large cap stocks, however, did not change its portfolio - because it isn't supposed to. The ETFs purpose is simply to track the index.

At the same time, concluding that based on past performance a Technology ETF is therefore a bad investment going forward, or that a small-cap ETF is therefore a good investment, is absurd. Tech stocks were a bad investment just as small caps were a good investment, in the past. That tells you almost nothing about how they are likely to perform in the future. Besides, unlike a mutual fund you can short an ETF, so even a poor investment, correctly identified, can be turned into a positive opportunity.

An Effective Wealth Management Tool

The need, therefore, for a fundamentally different approach to ETFs - a forward-looking approach - should become as clear as night and day. Fortunately there is a set of existing tools that can help divine a forward-looking measurement of an ETF's investment merit. One of the least-recognized but important advantages of an ETF is that they are transparent and, unlike a mutual fund, their holdings and weight in their respective index can be known at any point in time. It is then possible to marry the list of the holdings with all the available fundamental data about those holdings to create a very informative picture of the ETF as a whole and answer such important questions such as:

• Which ETFs offer the best earnings growth? The best dividend yields?

• Which are seeing estimates raised, and where are they getting slashed?

• Which show trouble brewing on the balance sheet?

• How is it valued, relative to expectations and relative to other ETFs?

This information can then be used to compare ETFs across categories or within categories. Why is this important? To date, financial advisors seeking to develop asset allocation plans based on their respective clients' goals, risks tolerances and time horizons have often had to make a leap of faith as to the best ETF within each asset class based on little or no information.

Tracking Small Cap Stocks

For example, two options for tracking small cap stocks are the iShares S&P Small Cap 600 index fund (IJR) and the iShares Russell 2000 index fund (IWM). Both are from ETF-giant Barclays, both have an expense ratio of 20 basis points, and both have three-star ratings from Morningstar™.

While these may seem like equal investments, would they still be considered equal if you knew that one index was trading at 18.3x estimated earnings per share this year and the other was trading at 22.8x? Would it differentiate the two if, wanting to position your portfolio for the next economic downturn, you knew that during the last recession profit margins for both indices declined but that the profit margins of one index fact turned negative?