When the world's first exchange-traded fund, the S&P 500 SPDR ( SPY), was listed over a decade ago, things were simpler. People were broadly familiar with the underlying index, and, assuming an investor already wanted to track it, explaining the advantages and disadvantages of the ETF structure versus that of a comparable index mutual fund was the only analysis necessary.

Since then, however, the number of ETFs available to investors has exploded. The array of over 400 choices and the flexibility it brings is positive, but having so many choices also complicates the selection process. How do I know which ETFs make the most sense for my portfolio?

Perhaps because ETFs have always been compared with mutual funds, analysts have started to evaluate them as if they were mutual funds. Morningstar, for example, the large mutual fund rating outfit, says in materials on its Web site, "The Morningstar Rating for exchange-traded funds uses the same methodology as the Morningstar Rating for mutual funds."

Therein lies the problem. Mutual funds are typically evaluated based on past performance and fees. That's appropriate for most of these products, which are actively managed, because what you are really doing is hiring a manager to invest on your behalf. But with ETFs, it's different. There is no active manager deciding when to buy or sell certain stocks -- no one, for example, deciding when to lighten up on a certain sector or when to increase exposure to a certain market cap segment.

There is nothing inherently good or bad about a particular index that an ETF tracks. Rather, the investment merit of an ETF is determined by two factors: market conditions and the fundamentals of the underlying stocks that comprise the fund. These, of course, change all the time.

This difference is like night and day: One is backward-looking, and one is forward-looking. Who is not aware that, over the past five years, technology stocks in general were a bad investment? What moderately informed investor doesn't already know that, over the same time period, small-cap stocks outpaced large-cap stocks?

If a mutual-fund manager failed to foresee changes in the economy and in the market and stayed overexposed to large-cap tech stocks, you'd have a valid complaint that he was probably not earning his keep. But the reason an ETF tracking an index of tech stocks, or an index of large-cap stocks, didn't change its portfolio is that it isn't supposed to -- it is just supposed to track the index.

To conclude that a technology ETF is therefore a bad investment, or that a small-cap ETF is therefore a good investment, is absurd. Past performance tells you next to nothing about how an ETF is likely to perform in the future. Besides, unlike a mutual fund, you can short an ETF, so even a bad investment, correctly identified, can be turned into a good thing.

So how do you determine the merits of investing in an ETF going forward? Fortunately, there is a set of existing tools that can help. One of the least-recognized but most important advantages of ETFs is their transparency. As a result, it is possible to marry the list of constituents with all the fundamental data available about those constituents to create a very informative picture of the basket as a whole.

One can find the answer to important questions such as:
  • Which ETFs offer the best earnings growth? The best dividend yields?
  • Which are seeing estimates raised, and where are they getting slashed?
  • Which show trouble brewing on the balance sheet?
  • How is a particular ETF valued, relative to expectations and relative to other ETFs?

You can use this information either to compare ETFs across categories or within categories. For example, two popular options for tracking small-cap stocks are the iShares S&P Small Cap 600 ( IJR) and the iShares Russell 2000 ( IWM). Both are from ETF giant Barclays, both have an expense ratio of 20 basis points, and both have three-star ratings from Morningstar.

So now what? If I told you that one of those indexes was trading at 18.1 times estimated earnings per share this year and the other was trading at 23.2 times, wouldn't that knowledge make a difference?

If you were concerned about a slowing economy and wanted to position your portfolio for the next downturn and if I could tell you that during the last recession profit margins for both indices declined but that for one of them profit margins declined much worse -- and in fact were negative -- wouldn't that information affect your investment planning?


To be sure, there is no guarantee that current expectations about fundamentals will prove to be accurate. And even if they are, there's no guarantee that the market will care about fundamentals in the near term. But over the long term, most investors believe that fundamentals such as earnings and valuations are what drive the stock market.

That is why before buying stock in, say , General Electric ( GE) -- which after all is really a collection of business not entirely different from an ETF -- most people would make an effort to compare GE's fundamentals to those of other industrial companies and to the market in general.

This is why I employ a fundamentally different approach to ETFs in my advice to clients, an approach that is rooted in fundamentals. This approach is intuitive, forward-looking and, I believe, a lot more relevant than past performance.
Michael Krause is president and founder of AltaVista Independent Research. AltaVista provides fundamentally driven analysis of exchange-traded funds to help investors select ETFs based on investment merit, much the same way they would evaluate a single stock. The firm offers both print and online ETF research to subscribers, but does not manage clients' money. Mr. Krause is also a frequent contributor to broadcast and print media.