When exchange-traded funds first hit the market, they were almost exclusively used to track indices such as the S&P 500.

With an ever-increasing demand for these baskets of securities that trade like stocks, ETFs have branched out to follow various sectors of business.

To identify the most-diversified ETFs, as measured by full exposure to all major sectors, TheStreet.com Ratings selected the funds reporting holdings in each of the following 12 sectors: basic materials, capital goods, communications services, consumer cyclicals, consumer staples, energy, finance, health care, technology, transportation, utilities and miscellaneous.

To ensure that a sufficient critical mass for influencing performance was present in each area, a minimum of 2% of assets had to be held in each sector.

The 10 ETFs passing the tests are listed in the table below. For each, the sector with the heaviest representation in the ETF's portfolio is listed, along with the fund's lightest sector holding.

In addition, the standard deviation of each fund's array of sector holding percentages is displayed. This is a measure of how close together the fund's percentage holdings of the 12 individual sectors are.

A low standard deviation means that the ETF is more evenly divided among individual sectors than a fund with a higher standard deviation is.

Thus, a low standard deviation of sector percentage holdings can be interpreted as an indication of less portfolio concentration and greater diversification.

Finally, the 12-month total-return performances and TheStreet.com Ratings grades for the ETFs are listed, in the below chart.

The Most-Diversified ETFs
Name and Ticker Symbol Heaviest Sector & Percentage Lightest Sector & Percentage Standard Deviation (%) 12-Mo. Total Return (%) TSC RATINGS GRADE
iShares Russell 2000 (IWM) Finance: 24.42% Transportation: 2.47% 6.59 18.26 D-
iShares S&P Small Cap 600 (IJR) Finance: 18.90% Communic. Svcs.: 2.70% 5.34 15.08 D
Vanguard Small Cap ETF (VB) Finance: 25.13% Miscellaneous: 2.42% 6.53 15.78 B-
Vanguard Small Cap Value ETF (VBR) Finance: 25.13% Miscellaneous: 2.42% 6.53 19.54 B+
iShares Morningstar Mid Core (JKG) Finance: 25.96% Transportation: 2.04% 7.72 14.22 B
iShares Russell Mid Cap Growth (IWP) Cons. Cyclicals: 18.75% Miscellaneous: 2.44% 5.88 10.51 C+
Vanguard Extended Market ETF (VXF) Finance: 26.15% Miscellaneous: 2.00% 6.63 14.38 C+
SPDR 500 (SPY) Finance: 23.96% Transportation: 2.03% 6.18 15.81 C+
iShares S&P Global 100 (IOO) Finance: 16.76% Communic. Svcs.: 2.53% 4.04 19.90 C+
streetTracks Dow Jones Stoxx 50 (FEU) Miscellaneous: 18.21% Energy: 2.19% 6.02 26.67 B-
Data as of 12/31/2006.
Source: TheStreet.com Ratings

If you were expecting that the list of highly diversified ETFs would be dominated by large-cap funds, you are in for a surprise. The largest grouping on the list, with four representatives, is the small-cap category of funds. Two of the small-cap funds earned grades from TheStreet.com Ratings in the "B" range, which equates to a "buy" recommendation, while the remaining two were "sells" in the "D" range. The differences are a result of variances in volatility, which, along with total investment return, is a factor in determining the ratings grades.

Two of the diversified mid-cap funds earned grades in the "C" range for "hold" recommendations, and one climbed into the "B" bracket. The lone large-cap fund held a C-plus, or "hold" grade.

The roster of sector diversification champions really gets interesting when looking at the two members with investment focus extending outside the U.S. As for the single truly foreign (no U.S. holdings) member of the group, one might wonder how a fund with only 50 holdings could be considered diversified. Yet the European holdings of ETF Dow Jones Stoxx ( FEU) were able to touch each of the 12 sectors needed to qualify for the list.

Whereas eight of the funds on the roster invest most heavily in the financial sector and one in consumer cyclicals, the Stoxx 50's biggest sector is the "miscellaneous" grouping, which by itself implies additional diversification.

While most of the lightest holdings for the group are in transportation, communications services or the miscellaneous sector, the ETF's lightest sector is energy, which would seem to be a rather good sector to avoid considering the recent drop in energy prices. The fund rewarded its investors with a total return of 26.67% in 2006, top of our funds list by a comfortable margin. That helped it earn a B-minus "buy" grade from TheStreet.com Ratings.

The iShares S&P Global 100 ( IOO) fund stands out in several respects as the most diversified of the group, despite its somewhat diminutive number of holdings. With its heaviest sector of "finance" representing only 16.76% of its holdings -- the lowest top sector among the funds on the list -- the Global 100 is the least concentrated and, therefore, the most sector-diversified of the group.

Its relatively even sector-distribution level is confirmed by its extremely low 4.04% standard deviation of sector percentages. As the group's only "global" fund investing internationally as well as domestically, it easily qualifies as at the most geographically diversified fund on the list. The Global 100's 19.90% total return for 2006 was the second highest on the list.
Widows is a financial analyst for TheStreet.com Ratings. Prior to joining TheStreet.com, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.