The Best ETFs of 2013

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Exchange-traded funds have maintained their immense popularity throughout the bull market as an increasing number of investors look at ETFs as a flexible, low-cost alternative to actively managed mutual funds. With thousands of different ETFs to choose from, though, finding the best ETFs can be a tough challenge.

Past performance is no guarantee of future returns, and blindly choosing the best ETFs of 2013 for your portfolio might well lead to disastrous results in 2014 and beyond. Nevertheless, it's worth taking a look at some of the best performers in the ETF world to find out what drove them higher and whether their gains are likely to continue next year and in the long run.

What worked in 2013
Guggenheim Solar
topped the list of returns among nonleveraged ETFs, rising 128%, according to year-to-date figures from Morningstar. The solar ETF wasn't alone in profiting from alternative energy, as several other sector funds posted similarly impressive returns. With substantial positions in winners like SolarCity and SunPower, the Guggenheim Solar ETF managed to claw back from extreme losses in recent years. Yet even with the Guggenheim ETF's gains so far in 2013, it still hasn't been enough to recover fully from its past declines. In fact, Guggenheim Solar still has an average annual loss over the past three years of more than 16%, showing that huge drops can be almost impossible to recover from, even after spectacular rebounds. If gains in demand for residential solar projects pick up steam, then solar stocks could easily see further rises in 2014.

VelocityShares Daily Inverse VIX also did well, doubling in price and extending its long winning streak. The specialty ETF tracks overall market volatility, with its shares rising when volatility levels fall. Throughout the past several years, the stock market has defied calls for bear market declines or even substantial corrections, resolutely plowing higher with only the briefest of interruptions. It's only a matter of time before the stock market meets resistance to its upward climb, but that doesn't mean that it has to happen in 2014. If it doesn't, then the VelocityShares ETF could see more strong performance.

This was a great year for financial companies, and the iShares US Broker-Dealers ETF rode that success to 62% gains in 2013. With holdings that include major Wall Street investment banks, well-known discount brokers, and the companies that own and operate major stock, bond, options, and futures markets, the iShares ETF tapped into the rebound in enthusiasm among investors that resulted from an especially strong year of returns in most of those markets. With financials having recovered from extremely depressed levels several years ago, many still believe they have further room to run as long as conditions in the industry remain relatively positive.

Other sector bets did well. PowerShares Nasdaq Internet gained 61% on the strength of technology stocks in the most popular subsectors in the space. In particular, social-media stocks, online-search providers, and streaming-video specialist Netflix helped provide the biggest returns. Moreover, the ETF dodged a big bullet by avoiding shares of some of the weaker-performing stocks in the tech world, especially more hardware-centric businesses. Some believe that Internet stocks are back in a bubble, but we all know how far stocks can climb under such conditions before pulling back.

Meanwhile, Market Vectors Biotech gained 60%, as biotech stocks in general roared ahead in 2013. It's hard to pinpoint any single stock in the space as having pushed the industry higher, with even the largest stocks in biotech posting outstanding returns. Going forward, biotech companies will have to demonstrate their ability to make good on the promise of their new developments during 2013. For now, though, investors remain excited about their future prospects.

Why ETF investing is so successful
The ability to pinpoint lucrative areas of the markets is one key reason why ETF investing has become so popular. You won't always be able to predict which ETFs will be the best, but by seeing how the trends that dominated the past year contributed to the performance of the best ETFs of 2013, you'll be better able to take advantage of future trends to make smarter investing decisions.

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Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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