The Biggest ETF Turkeys of 2008

The yearlong bear market has done little to stem the flood of exchange-traded funds. At last count there were more than 700, a 25% increase from a year earlier. These ETFs currently hold about $579.5 billion in combined assets. With so many funds now out there to choose from, and so much investor cash on the line, we decided it's time to flag the worst-performing ETFs of the bunch.

Using the SmartMoney.com ETF Screener, we identified several ETFs that are underperforming the S&P 500 index, a common benchmark, by several points on a year-to-date and five-year basis. At the same time, some of these laggards are trading at a premium to the broad index in terms of their average price-to-earnings and price-to-book ratios. (See chart below.)

Since most ETFs passively track indexes, they don't have active managers at the helm to criticize for making bad picks. So if a subpar manager isn't to blame, what is? At the top of the list is over-concentration. A common complaint about some ETFs is that they slice and dice the market so finely that investors can take harder hits vs. more diversified offerings. And, lo, the two worst ETFs so far this year are narrowly focused Holdrs funds from Merrill Lynch (MER). Both Internet Holdrs (HHH) and Internet Infrastructure Holdrs (IIH) invest in just a handful of web stocks. IIH, for example, has a whopping 61% of its assets invested in a single stock: VeriSign (VRSN).

The shortfalls of the ETFs on our list don't end with diversification. Sector, market capitalization and style also played roles. Diversified technology-focused ETFs figured prominently into the mix (SPDR Morgan Stanley Technology (MTK) and iShares S&P Global Technology (IXN)), as did small-cap and midcap ETFs, especially those with growth biases (iShares Russell Midcap Growth (IWP) and SPDR DJ Wilshire Small Cap Growth (DSG)).

Do the failing of a few funds mean it's time to give up on ETFs? Hardly. By and large the mood on ETFs remains positive. As of September, ETFs garnered $82 billion in net inflows while mutual funds have suffered record redemptions, according to Morningstar.

"At their very core, ETFs are really passive indexes so it's hard to say a particular ETF is disappointing," says Morningstar analyst Scott Burns. "There are definitely ETFs that have had a hard time, reflective of the harder market. ETFs in general have been doing their job."