The Wall Street Journal-20080204-Investing in Funds- A Monthly Analysis- Exchange-Traded Funds- Taking Inventory- The many ETFs hitting the market last year got a lot of hype- What did investors actually buy-

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Investing in Funds: A Monthly Analysis; Exchange-Traded Funds: Taking Inventory; The many ETFs hitting the market last year got a lot of hype; What did investors actually buy?

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Last year, 290 new exchange-traded funds hit the market, according to Morningstar Inc., nearly doubling the number available and vastly expanding the choices investors have with these cousins of index-based mutual funds.

So what did investors actually buy?

We decided to crunch numbers on the Class of 2007 to get beyond the hype. The year ushered in offerings that go well beyond the broad- based stock-market exposure of the original ETFs, tapping more heavily into foreign markets and featuring new ways to invest in bonds, commodities, currencies and industry subsectors -- and to bet against many of these areas.

Using Morningstar data, we focused heavily on the 50 biggest and 50 smallest ETFs that had six-month track records. The smallest of these big ETFs had $56 million in assets as of Dec. 31, and the biggest of the 50 smallest had $5.3 million.

We quickly learned that attracting business is far more than a function of how long a fund has been on the market: Of the biggest 50 overall, 10 were launched in the second half of the year, including one in November, UltraShort FTSE/Xinhua China 25 ProShares ETF, which bets against long-highflying Chinese shares. It had $374 million under management at year end.

Certain trends were obvious: While foreign markets have taken a pounding in recent weeks, they were hot last year, and U.S. investors favored many new ETFs that invest overseas. As for ETFs focused on the U.S., investors foresaw some of the declines that have hit American stocks this year and pumped money into a number of the ETFs that make bearish bets. In another move reflecting jitters about U.S. stocks, they flocked to many of the new bond ETFs.

At the same time, they shunned ill-timed ETFs focused on the struggling U.S. real-estate sector. They also largely bypassed some of the most narrowly focused and obscure ETFs, like HealthShares Infectious Disease ETF.

The industry's giants fared well: Thirty-four of the 50 biggest ETFs are from Barclays PLC's Barclays Global Investors unit, State Street Corp.'s State Street Global Advisors, Vanguard Group Inc. and Invesco Ltd.'s PowerShares Capital Management. These companies have experienced sales forces to explain and pitch new products to financial advisers.

Here is a closer look at the year's sales activity:

-- BIG SALES IN HOT AREAS: Many of the top-selling funds focus on market areas that continued to perform strongly last year, like natural-resources and foreign stocks.

International stock and bond ETFs loom especially large in the biggest 50. There were five world bond funds, three foreign funds that focus on large stocks of various investment styles, three diversified emerging-markets funds, one foreign fund focused on shares of rapidly expanding small and midsize companies, three funds focused on the Pacific Asia region, one Europe stock fund and one international real- estate fund. There also were a handful of natural-resources ETFs with global exposure.

The biggest ETF: Vanguard FTSE All-World ex-U.S. ETF, which tracks an index of global shares excluding the U.S., grew to $1.32 billion from its March launch through December. It returned 4.1% in the second half.

PowerShares DB Agriculture, which tracks an index of agricultural commodities futures, held $1.09 billion at year end. It returned 27.1% for the last six months of 2007; agriculture stocks and commodities have benefited from growing demand in fast-developing countries like China. CurrencyShares Japanese Yen Trust, from Security Benefit's Rydex Investments unit, stood at $987.7 million as of Dec. 31. It had a 10.4% return for the second half.

The ETF with the strongest performance in the year's second half was $238 million Van Eck Global's Market Vectors Global Alternative Energy. It was up 39.1%. State Street's SPDR S&P China, with $192.4 million under management, returned 37.6%.

ProFunds Group's UltraShort Financials ProShares returned 36.9%. Along with the bearish China ETF, it was one of a series of funds launched by the Bethesda, Md., firm to bet against parts of the markets. The $966.5 million financial-services ETF was a vehicle for investors to bet against banks, insurers, securities brokers and other financial stocks amid the subprime-mortgage meltdown.

-- LIMITED SALES OF NARROW ETFS: As narrow ETFs hit the market last year, critics warned that smaller ETF firms' efforts to distinguish themselves had led to offerings too narrowly focused for most small investors' purposes -- and that these ETFs would be highly volatile. The ETF firms responded that the ETFs can be used to plug holes in investors' portfolios, among other uses.

The critics seem to have won the argument: Especially narrow ETFs didn't draw much investment.

And they were right about volatility: Eight of the 18 health-care subsector ETFs introduced by XShares Advisors LLC in the first half of the year declined by double-digit amounts in the last six months of the year, a far-worse performance than comparable broad-based health- care ETFs.

HealthShares Infectious Disease ETF was the worst-performing of the family, down 23% in the last six months of 2007. Launched April 3, it held $1.9 million under management as of Dec. 31. The best-performing was the $9.9 million HealthShares Cancer ETF, up 22.5%.

The biggest new ETF in the HealthShares family: the $52.6 million HealthShares Diagnostics ETF, which returned 17.3% in the second half. Most of the HealthShares ETFs held between $2 million and $3 million at year end.

"This year we'll be focused on growing assets in those funds," says XShares Chief Executive Anthony Dudzinski. An ETF generally needs assets greater than $50 million to $100 million to start generating positive cash flow, Mr. Dudzinski says. The larger funds will support the smaller ones until they catch up, he adds, a practice that is common in the ETF world.

Mr. Dudzinski doesn't buy into the criticism that the funds are too narrowly focused; he says adviser feedback is mostly positive for narrow ETFs. He believes the funds will grow with time, as they are better understood and as more investors develop an interest in health care.

-- BIGGER PLAYERS' MARKETING EFFORTS PAY OFF: Despite some solid performance gains, numerous offerings from newcomers to the ETF field failed to attract as much investor interest as those of the industry's giants. Why did they struggle? Marketing.

Ameristock/Ryan 20 Year Treasury ETF returned 11.4% in the second half of 2007, while Ameristock/Ryan 10 Year Treasury ETF returned 10%. Both funds, launched in June, track the Ryan Treasury Indexes. Those solid gains reflected the rush by jittery bond-market investors into the relative safety of U.S. government debt, which drove up bond prices.

Yet the Ameristock funds held less than $3 million apiece at Dec. 31. The problem is that Ameristock, a newcomer to the ETF world, introduced the ETFs at the same time that some of the giants already were promoting their bond ETFs. Barclays' iShares Lehman 10-20 Year Treasury ETF, which was up 10.2% in the second half, had $83.8 million under management as of Dec. 31. It debuted in January.

"When you're not the first to market in the ETF world, it is a much more difficult sale," says Nicholas Gerber, president of Ameristock Funds, Alameda, Calif. The firm doesn't have a team dedicated to selling its ETFs to the biggest brokerage firms; instead, it sells to thousands of financial advisers. "It takes awhile to educate this group on why we're different," he says, adding that the company has the wherewithal to stage a ground war for the three years it usually takes a new business to get off the ground.

Relatively strong performance didn't translate into big sales for First Trust Materials AlphaDEX ETF, either. The fund, introduced in May by ETF-newcomer First Trust Portfolios LP, returned 8.5% for the year's second half, on the strength of mining and oil-equipment companies. Its size as of Dec. 31: $3.3 million.

First Trust Health Care AlphaDEX was one of only four of the 22 health-sector ETFs from the Class of 2007 in the black for the second half, returning 2.5%. Yet it didn't attract significant investor dollars; it had just $1.6 million in assets at year end.

First Trust, which markets products through financial advisers, says the AlphaDEX funds were vying for attention in a year when competition among new funds was fierce. The company expects investment flows to grow in the years ahead, as more investors learn about the ETFs and their performance.

Even the powerhouses had some new offerings that didn't sell well. PowerShares launched Dynamic Europe and FTSE RAFI Europe last June. Dynamic Europe, with $7 million under management, was down 3.9% in the second half. The $10.2 million FTSE RAFI Europe was up 3%.

PowerShares CEO Bruce Bond says that the market is still digesting some of the new offerings and that sales will grow as investors learn how to use more targeted ETFs in their portfolio. "We're going to continue to support them," he says, adding that the ETF market is still developing and that it is premature to dismiss the smaller funds.

-- EXPENSES NOT A BIG FACTOR: In general, an advantage of ETFs over conventional mutual funds is much-lower costs to investors.

The average annual expense ratio for a U.S. stock ETF has risen to 0.53% of assets, from 0.43% early last year, reflecting that ETFs have become more complicated, with some charging as much as 0.95%, according to Morgan Stanley. The average U.S. index-based mutual fund charges 0.72%.

No clear trends jumped out in our analysis on how cost played into investors' decisions. At least five of the 50 biggest funds had expense ratios of 0.95%.

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Ms. Scism is a news editor for The Wall Street Journal in South Brunswick, N.J. She can be reached at [email protected]. Ms. Badal is a staff reporter for the Journal in New York, at [email protected].