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ETFs We Would Like to See in 2010

Three ideas that would help investors in the new year.

Bradley Kay, 12/31/2009

We had another ETF bonanza this year, as 135 new exchange-traded funds and notes entered the market so far in 2009. As usual, these new investments ran the gamut. Some broke entirely new ground for individual investors, such as iPath S&P 500 VIX Short-Term Futures ETN VXX. Some covered the same asset classes we've seen dozens of times before but tried to do it better and cheaper, such as Schwab's new ETF lineup. Others rounded out the lineup of available ETFs with useful variations on existing products. A number just made us wonder why. (The much-mocked Oklahoma ETF OOK comes to mind). But that is a story for next week, when we review 2009 by the numbers and discuss some of the best, worst, and most interesting ETF developments from the past year. For this last article of the year, we are going to talk about the future.

Morningstar data shows 926 ETFs and ETNs currently trading in the U.S. market, an imposing variety. When fund companies start issuing index funds based on niches like Chinese technology firms, surely we've hit the limit of how global capital markets can be sliced and diced? Yet our team has identified three ideas for new index funds we would like to see in a liquid, ultra-low-cost ETF package. So here they are, our ideas for new ETFs we would like to see in 2010.

International Credit Bonds
One very surprisingly sparse sector in the ETF universe is non-U.S. dollar bonds. Only five U.S. ETFs fall into the world bond category, all of which invest solely in sovereign bonds issued by foreign governments. Two more ETFs invest in sovereign bonds issued by emerging-markets countries. Only seven funds invest in foreign bonds. There are just as many ETFs devoted to tracking the price of gold and its futures.

We would like to see foreign credit bonds available in a low-cost ETF. This exposure would not only provide the diversification of foreign currency exposure and interest rates, but would also allow U.S. ETF investors to tap into overseas credit risk. Credit risk in corporate bonds provides one of the best ways to benefit from macroeconomic growth and stability elsewhere in the world, without taking on all the risk of international equity investments.

Best of all, foreign corporate bonds are becoming a much more liquid and diverse asset class these days. As banks shore up their capital and scale back on lending worldwide, European and Asian firms that previously would have relied on bank loans have instead turned toward newly revitalized bond markets. Trading costs have fallen, the number and variety of issuers have gone up, and the diversification benefits of foreign corporate bonds will surely rise as well. This is probably the single largest asset class still untouched by the U.S. ETF market, and providers such as iShares already carry euro and pound-based corporate bond funds in their European ETF offerings. Here's hoping that some of these funds cross the pond in 2010.PAGEBREAK

International Quality Stocks
The stock market rallies in 2009 were strongest among the most marginal businesses that just managed to hang tough through the worst of last fall and winter. As a result, these mediocre businesses often trade at valuations similar to, or even richer than, quality companies that produce juicy profits year in and year out. These quality companies, whose wide moats and superior operations have traditionally generated greater returns over long periods, look like one of the few bargains left in the global stock market.

In the U.S., ETF investors can tap into these companies using our analyst favorite Vanguard Dividend Appreciation VIG, which holds stocks of companies whose strong earnings and secure balance sheet have supported 10 consecutive years of dividend increases and look primed to keep it up in the future. Unfortunately, no ETF captures a similar variety of high-quality companies outside the United States for such a low cost. PowerShares International Dividend Achievers PID comes closest, with a similar dividend screen for its holdings, but it can only hold ADR shares of foreign companies and has some downright odd portfolio weightings. (Mexican regional airport operator Grupo Aeroportuario del Sureste takes up 4.7% of the assets, while global mega-bank HSBC HBC takes up only 1.3%.)

We would love to skew our portfolio toward quality stocks for the long run, but we don't want to give up our international-equity diversification. Especially not when foreign stocks look cheaper by most valuation metrics. ETF providers, please give us a low-cost way to buy the Nestlés, the Toyotas, and the BHP Billitons of the world in one sensible fund.

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