Where the Hot Money is Headed in 2012

Despite the many risks floating around in the global economy right now, so far this year those concerns have taken a backseat to increased risk tolerance. Investors have rediscovered their appetite for risk and helped drive the stock market up roughly 4.6% in the opening weeks of 2012. Riskier small-cap stocks and high-yield bonds are leading the market as investors begin to regain confidence in the economy's staying power.

Of course, there's one other investment that has been cleaning up in recent weeks: exchange-traded funds. 2011 was one of the worst years in nearly a decade and a half for active management, with scores of hedge funds and actively managed mutual funds trailing the market by wide margins.

Perhaps not surprisingly, investors have been shifting assets en masse from actively managed funds into ETFs. In fact, so far in 2012, ETFs have garnered $8.3 billion in new assets, while active funds have seen $7.9 billion in outflows. So if you're one of the millions of investors thinking about getting in on this trend, there are a few things you need to consider.

1. If you're going to buy ETFs, make sure you buy the right ones
If you think of ETFs as sexy, exciting investment vehicles that can double your money in short order, you're going to need to adjust your thinking pretty quickly. ETF investing shouldn't be exciting; it should be boring and rather low-key. Stay away from flashy new funds that invest in small segments of the market like semiconductors or European financial stocks or funds that are highly leveraged. Instead, build your ETF portfolio on the backs of well-diversified, low-cost funds that cover large segments of the market.

But what if you think the tech sector is going to take off and you want some dedicated exposure to that corner of the market? Instead of buying an outrageous fund like Direxion Daily Technology Bull 3X Shares ETF, which offers 300% of the daily return of the Russell 1000 Technology Index, consider a more broad-minded fund with a growth orientation. For example, the Vanguard Growth ETF (NYS: VUG) has a 28% allocation to the tech sector, while the Schwab U.S. Large-Cap Growth ETF (NYS: SCHG) measures in with a 27% exposure.

Likewise, if you think banks will experience a renaissance this year, avoid loading up on focused sector fund SPDR S&P Bank ETF (NYS: KBE) . Instead, opt for the broader value-tilted SPDR S&P 500 Value ETF (NYS: SPYV) , which has a large allocation to financials. Avoiding narrowly focused sector funds in favor of broader funds will still provide you with exposure to your desired sector while keeping risk to a minimum, thanks to the funds' wider diversification mandates.

2. Make sure you're not using ETFs to time the market
A fair number of investors prefer exchange-traded funds to traditional mutual funds because of their greater trading flexibility. ETFs can be bought or sold throughout the trading day, unlike stodgy old mutual funds that trade just once at the end of the day. While this increased flexibility is nice, try not to see this as a license to engage in frequent trading. ETFs should be bought and held for the long run, not in an attempt to time the market. Study after study has shown that most investors are horrible market timers, so the only way to win this game is not to play. Buy your ETFs and sit on them until you need to rebalance or until some other factor triggers a re-examination of your original thesis for owning the funds in the first place.

3. Don't chase performance!
While I think that exchange-traded funds are a great innovation and a wonderful tool for investors looking to get broad market exposure at a low price, the cynical side of me sees this rush to ETFs as nothing more than performance-chasing. Active funds had a bad year, so investors are rapidly bailing out on them in search of greener pastures. We can observe this kind of behavior all the time as market shifts bring different investing styles or asset classes into or out of favor. It's practically a certainty that large numbers of investors end up chasing whatever investments have done well in the recent past. Of course, given this rearview-mirror thinking, it's also not surprising that most folks who engage in this type of behavior also end up losing out as they are continually chasing yesterday's winners.

Sooner or later (maybe even this year), actively managed funds as a group will have a terrific year and slam the market average -- at which point many investors will suddenly remember that they love actively managed funds and pile back in, leaving ETFs as quickly as they flooded in. Through the years, there will be periods when active strategies outperform and periods when passive strategies outperform. Investors can successfully use both approaches in their portfolio, but you need to do so with a long-term focus, and not in an attempt to capitalize on the recent top performers.

ETFs can serve a vitally important role in your investment portfolio. Just make sure you're using them correctly and consistently, rather chasing a hot trend that could just as quickly turn cold.

Regardless of whether you prefer actively managed funds or exchange-traded funds, both types of investments can help you reach your retirement goals. Our newest special free report highlights the shocking truth about your retirement. Don't miss this chance to grab your free copy of this can't-miss report today!

At the time thisarticle was published Amanda Kishis the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein.Tryany of our Foolish newsletter servicesfree 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 adisclosure policy.

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