The Best and Worst ETFs of 2012


In recent years, exchange-traded funds have been all the rage. Billions of dollars have flowed out of traditional mutual funds and into ETFs as investors increasingly embrace the philosophy that it makes more sense to buy index-tracking passive investments than to pay up for the active management that so many mutual funds rely on.

ETFs undeniably have some common benefits, including ease of trading, tax efficiency, and in many cases, lower costs. But even with those common traits, the ETF universe definitely had its winners and losers this year. Let's take a closer look at the best- and worst-performing ETFs so far in 2012.

The biggest movers: Bets on black swans
Without a doubt, the biggest players in the ETF space this year came from volatility ETFs. Looking at the rankings, three of the four top-performing ETFs were linked to volatility, while all seven of the worst performers were volatility ETFs.

The mechanics of the various volatility ETFs differ in meaningful yet highly intricate ways. Yet when you reduce them to their common essence, volatility ETFs essentially allowed investors to bet on whether there'd be a crash-producing event in the stock market at some point this year. Despite worries about the European sovereign debt crisis, the slowdown in growth in China, and ongoing troubles in the U.S. tied to events like political dysfunction and a lack of fiscal discipline, stocks almost completely avoided the turbulence that many expected to see.

As a result, ETFs designed to rise when volatility fell performed extremely well. VelocityShares Daily Inverse VIX ETN nearly tripled, while a similar ProShares fund posted a 190% gain.

But on the other side of the coin, ETFs that counted on a black swan event for gains lost nearly all of their value. The leveraged ProShares Ultra VIX Short-Term ETF and VelocityShares Daily 2x VIX Short-Term ETN both fell by more than 97%, while even the unleveraged iPath S&P 500 VIX ST ETN plunged nearly 80%.

Some industry winners
Some leveraged sector ETFs also defied the odds by posting amazing gains. Direxion ETFs that specialize in the retail and financial industries produced impressive gains, thanks to good performance in their underlying indexes and a lack of volatility that would have introduced decay due to the daily focus of the products. For retail stocks, a rebound in consumer sentiment throughout the year has helped stoke sales. At banks, on the other hand, improving capital reserves and continued low interest rates have helped the most threatened banks get their feet back underneath them, pushing share prices higher.

Among ordinary ETFs, the big winner was the iShares Dow Jones US Home Construction ETF, which rose by 77%. That may sound like an impossibly huge move, but many of its stock holdings have seen even sharper rebounds as buying activity has finally started to pick up again. PulteGroup has seen its stock triple this year, while Lennar has doubled. Lennar in particular looks attractive due to its industry-leading margins, and it has also shown good judgment in selecting markets where housing demand is sufficient to push home sales higher even when prices aren't rising enough to lure buyers seeking investment opportunities.

Can 2012's winners repeat in 2013?
After a disaster-free 2012, it's a lot to ask for the stock market to maintain its low-volatility path in 2013. Consider, though: If volatility-ETF returns reverse themselves, so that this year's losers triple while this year's winners lose 90% or more of their value, then both sets of ETFs will have total-return losses over the two-year period. That's a losing proposition no matter which side of the bet you take.

As for homebuilders, financials, and retail, expectations are still relatively low for economic growth. A return to recession could reverse those gains, but growth in excess of modest expectations could lead the sectors to repeat in 2013.

2012's performances are nearly in the books, but which stocks will reign supreme in 2013? Find out which stock The Motley Fool's chief investment officer has selected his No. 1 pick for the next year in our brand-new free report: "The Motley Fool's Top Stock for 2013." I invite you to take a copy, free for a limited time. Just click here to access the report and find out the name of this under-the-radar company.

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