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Flexible, low-cost and with an abundance of options, exchange-traded funds continue their meteoric rise. The amount of money in locally listed ETFs increased by 35 per cent over the 13 months to January 31, according to ETF Consulting, hitting a record $6.5 billion.

As ETFs gain in popularity, more are addedto the menu. Fixed-interest ETFs made their first appearance in 2012, representing a landmark moment: investors can now put together a complete diversified portfolio using only ETFs: local and international shares, bonds and property as well, via real estate investment trust ETFs.

Meanwhile, strategy-biased funds, such as high yield and value ETFs including one based on analyst recommendations are offering ever more options for individual investors to consider.

Passive outperforms

Its impossible to talk passive funds ones that seek to re-create rather than beat a given benchmark without referring to how they perform relative to active funds, where highly paid professionals try to add value bystock-picking. Investing is typically a relative game for money managers: as long as they beat the market, they have earned their dough.

Matt Levine, on National Public Radios podcast Planet Money, neatly summed up the evidence in favour of passive over active management: everyone looking for average results gets average results; everyone looking for above-average results on average gets below-average results.

Once you get your head around that, turn your attention to a horde of evidence suggesting that most active managers struggle to beat the index. Over five years to June 30 last year, 69 per cent of funds with the S&P/ASX 200 Index as a benchmark failed to add value, according to Standard & Poors. It was a similar ratio for managers of Australian global share funds: nine in 10 active bond fund managers were outperformed by the index, and almost two-thirds of real estate investment trust managers. The numbers over one-year and three-year time horizons were generally less flattering.

The big exception was small-cap managers: eight out of 10 beat their benchmark. So, sure, there are some market maestros who beat the market consistently we interview them often in these pages. But aside from the small cap sector, these gurus are the exception rather than the norm.

Spoilt for choice

There are now 85 ETFs listed on the Australian Stock Exchange you can see all of them listed in the tables below. Weve grouped them according to asset class, the exception being the strategy ETFs, such as the new and already wildly popular high-yielding funds, which are discussed in more detail below.

With so many funds on offer, often over the same index, it can be tough to decide which you should invest in. For example, in our best performing ETFs table the Aii S&P/ASX 200 Financials ex-A-REIT fund is the best performer over the year to January with a whopping 33.9 per cent return. State Streets SPDR ETF over the same index was up 33.2 per cent over the same period.

Which to choose? Morningstar research analyst Alex Prineas has a simple strategy: look for the lowest-cost ETF offered by the most capable provider. ETFs are a scale business, Prineas says. Youre less likely to have a problem with a large, established player than with a very small ETF.

When looking for the lowest-cost manager, its not just about the ongoing management fee. You also need to consider the bid-ask spread, and whether the fund is trading at a discount or premium to the market. Once again, bigger funds over well-established indexes will tend to be more liquid and so have tighter spreads.

When it comes to trading global shares, you may be better off buying and selling when the overseas market is trading, Prineas suggests. For example, buy your Asian share ETF in the afternoon when those bourses are trading. As a rule of thumb, avoid transacting in the opening or closing 15 minutes of the days trading.

Strategic investing with ETFs

The most enthusiastically embraced ETFs of2012 were a new breed of yield-focused funds. Four of the five now listed the iShares, Russell, SPDR and Vanguard funds track an underlying index that has a dividend focus (see Australian Shares Strategy ETFs table). The biggest outlier is the iShares fund, which limits an individual holding to 5 per cent of the portfolio. The result is the companies held in the fund will move further down the market cap spectrum; the banks, for example, wont dominate as much as in the others.

BetaShares is probably the most innovative provider in the market it introduced Australias first inverse fund, which goes up when the market goes down and vice versa. (ASIC does not recognise this Bear fund as an ETF, hence it is not included in our table.) BetaShares Equity Yield Maximiser ETF follows a top 20 index, but then sells call options over its holdings. This generates extra income for the portfolio but will cap upside returns as buyers of the options can exercise their right to buy the funds stocks at a lower price should the market surge.

Two other strategic funds are the Russell Australian Value ETF, which tracks an index biased towards companies that display value characteristics. This is measured by prospective price-to-earnings based on the estimated profit per share over the coming three years.

Finally, one of the more interesting funds is the UBS IQ Research Preferred Australian Share Fund. It follows an index the Swiss investment bank created of about 40 companies that have each been given a buy rating by UBS analysts.

Aii S&P/ASX 200 Financials ex-A-REIT ETF