Are You Choosing the Wrong ETFs?

Exchange-traded funds (ETFs) have grown very popular in recent years, with many new ones introduced annually. A quick look at the size and performance of many of them, though, reveals that lots of investors are piling into poor choices and ignoring promising funds.

Biggest and best
Some of the biggest ETFs are indeed the right ones for many investors. They're the ones fulfilling an original goal of ETFs: to track certain broad-market indexes and offer investors an easy and efficient way to invest in them. The biggest one, for example, is the SPDR S&P 500 Index ETF (SPY), tracking the 500 big American companies in the S&P 500. That index alone represents about 75% of the entire American stock market. The Vanguard Total Stock Market ETF (VTI) gives you the whole U.S. market, and the Vanguard Total World Stock Index ETF (VT) gives you the rest of the world. Those who want to focus some of their money on just one big segment of the global stock market can do so with an ETF such as the Vanguard MCSI Emerging Markets ETF (NYS: VWO) .

Ooh ... something shiny!
Others among the biggest ETFs can be more problematic. The SPDR Gold Trust ETF (NYS: GLD) , for instance, briefly took over the top spot from the SPDR S&P 500 and currently has about $64 billion in assets under management. It does offer a simple way for investors to instantly devote a chunk of their portfolio to gold, but gold has soared so much in recent years that many see it as overvalued now and due to stall -- or fall.

Gold ETFs, as well as ETFs that own shares of companies that mine precious metals, are not your worst option, at least if you're just allocating a modest portion of your portfolio to them, in the hope that they might provide some stability in the face of further market mayhem. Indeed, some gold and silver stocks have a lot going for them. Yamana Gold (NYS: AUY) , for example, spent just $50 producing each ounce of gold it sold in 2010 -- and gold has been selling for more than $1,000 per ounce for quite some time. Silver Wheaton (NYS: SLW) is enjoying relatively low fixed costs while projecting big production increases.

Another not-quite-as-great-as-it-seems ETF is the iShares Barclays TIPS Bond ETF (NYS: TIP) , which has a built-in feature that adjusts your return for inflation. That's nice, but it also offers a very paltry payout these days, with interest rates so low. And as my colleague Dan Caplinger has noted, your personal inflation might differ from the official rate the investment uses. (If you have a large family and live carless in a city, for example, you might be much more affected by changes in the price of food than the price of fuel.)

Risk -- times three
Let's move away from the absolute biggest funds now and look at some troubling funds. One of the most dangerous kinds of ETFs to own is kind that uses leverage to double or triple the market's returns. Obviously, that's quite an attractive prospect if you expect the market to rise -- but it can be excruciating when the market surprises you. Worse still, an ETF such as the Direxion Daily Financial Bull 3X Shares (NYS: FAS) tracks the daily returns of financial stocks, and a little attention to the math reveals that if you're not paying attention and you hold it for longer periods of time, you'll often see its performance start to drop off from the triple returns you might expect. No wonder Travis Hoium has deemed these "the riskiest investments on Earth."

Funds that short a segment of the market can also be dangerous. If you're thinking that gold and silver have risen too much and are sure to fall, you might fall for the ProShares UltraShort Silver ETF (NYS: ZSL) , which doubles down on its anti-silver position. Silver may indeed plunge one day, but if it takes a while to do so, you can lose out. This ETF lost 73% in 2009 and 80% in 2010, and it's down more than 60% so far this year.

Underloved but lovable
So what ETFs should you look at? Here are some that have attracted relatively few investors but deserve more love. They're generally small, and it's true that small funds can end up out of business, but if that happens, you'll typically just get cashed out or will have your investment moved into another fund. It's not the end of the world -- unless its performance has stunk.

Consider, for example, the new Focus Morningstar US Market ETF (FMU), which gives you most of the American stock market with a record-low annual fee -- just 0.05%. Or look at the First Trust Large Cap Core AlphaDEX ETF (FEX), which improves on the S&P 500 by eliminating about a quarter of its components, the ones deemed least promising, and beating its performance.

Zeroing in on smaller niches, look at the PowerShares Global Agriculture ETF (PAGG), if you see our planet's relentlessly growing population demanding more and more food. If you believe that software companies will prosper in our increasingly digital world, you might add the new and tiny SPDR S&P Software & Services ETF (XSW) to your watch list. There are all kinds of smallish ETFs that can serve you well if you manage to find them.

For some great ETF investing ideas, take a look at The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery."

At the time thisarticle was published Longtime Fool contributorSelena Maranjianholds no position in any company mentioned. Check out herholdingsand a short bio. The Fool has sold short shares of SPDR S&P 500. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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