Break out the champagne. Exchange-traded funds had a banner year in 2007. The industry gained 10% in assets in the fourth quarter alone, climbing to $608 billion. It was an impressive showing given a fairly challenging quarter in the markets, with the S&P 500 index dropping 5% and the dollar continuing to weaken. Observers say the cost-effective, tax-efficient instruments can look forward to continued growth in 2008, by building on popular product introductions from last year-a roster which included funds that track a wider array of currencies and commodities, municipal bonds and more international funds.

"We continue to see incredibly strong interest from investors and advisors in ETFs as a way to diversify portfolios and access different asset classes in portfolios," says Tom Anderson, head of ETF research at State Street, one of the biggest managers of the popular products. According to his data, through the end of November, the lion's share of asset flows industrywide went to international, fixed income and commodity-oriented funds-a trend that had been consistent throughout 2007. "The dominant themes were exposure not correlated to the U.S. dollar. International exposure gets you away from the dollar and U.S. stocks," Anderson says.

Escaping the U.S. Dollar

Large institutional investors have been increasing the amounts of their portfolios devoted to international stocks and bonds, Anderson says. "We think you'll see that trend continuing to spread to advisors and their investors as well in 2008," he notes. In 2007, more than one-third of the asset growth in ETFs came from international funds, or $59 billion of the industry's total growth of $187 billion, according to State Street.

That figure represents a whopping 54% growth in 2007. What's more, it makes international funds the single largest area of growth in 2007, as well as 2006, Anderson says.

Jeff Ptak, ETF analyst at fund tracker Morningstar, observes that funds investing in foreign stocks are getting sliced more and more narrowly, as the industry works to cover every corner of the market. "Country [funds], regional caps, diversified foreign small cap-if we don't have them yet, we will soon," he predicts.

Another way investors chose to diversify their portfolios away from the U.S. dollar was with other currencies. ETFs such as CurrencyShares from Rydex, allows investors to hedge their dollar exposure with foreign currency, easily and cheaply. Before ETFs hit the currency market, investors could use futures contracts, but they often required opening a separate brokerage account. Plus, the hefty contract sizes and substantial transaction costs were usually prohibitive for all but institutional investors.

A third way investors hedged their exposure to the U.S. dollar last year was with gold, which tends do well when the dollar does poorly, and is also uncorrelated to stocks and bonds. State Street's streetTRACKS Gold shares held $17.5 billion in assets as of Jan. 3, and returned about 16% in the fourth quarter of 2007.

An array of commodities-based ETFs also expanded to help investors diversify their portfolios in 2007, with more on the way in 2008.

Munis for Everyone

Meanwhile, as investors watched a declining dollar and choppy U.S. equity markets eat away at returns, they turned increasingly to tax-efficient instruments. So it was a no-brainer that they snapped up the new ETFs that tracked municipal bonds, which were introduced in September. There were 12 new muni products on the market last year, according to Morningstar. Most of the new offerings came from industry giants, State Street and Barclay's Global Investors. "It's a welcome development introducing indexing to this part of the market," Ptak says.

However, analysts note that the muni bond market is notoriously illiquid, making it a challenge to indexers to track efficiently. So it remains to be seen how closely the new instruments will be able to track the muni bond market. To get around the difficulty, issuers have stuck to the largest, most liquid markets. New funds are tracking the Lehman Brothers U.S. Municipal Index and muni bonds from the high-tax states of New York and California. In spite of the muni ETFs' short track record, there is more good news. Ptak says the new crop of ETFs are reasonably priced. State Street's product tracking the Lehman Municipal Bond index, the SPDR Lehman Municipal Bond ETF, has an expense ratio of 0.2%. That compares with an expense ratio of just over 1% for the average muni bond fund.

What's more, munis are a good buy at the moment, because their taxable yields are trading about equal to U.S. Treasuries. Ordinarily, munis yield less than U.S. Treasuries because munis have more favorable tax treatment. For example, say an investor owned a taxable bond and was paying a 40% tax rate. The investor would have to be getting a 5.8% yield, called a taxable equivalent yield, to equal the 3.5% yield a comparable muni might pay.

But recently, muni bonds have been paying a better rate even before taxes than U.S. Treasury bonds. The yield on the Lehman Brothers U.S. Municipal Index was at 4.02% as of Dec. 13, while the yield on the Lehman Brothers U.S. Treasury Index was 3.72%.

Munis are not the only fixed income game in ETF-town. The first investment-grade, corporate bond fund was rolled out by Barclay's Global Investors under its iShares brand a few years ago. Last year, 36 taxable bond ETFs made their debut, according to Morningstar.

A new fund that satisfies investors' appetite for fixed income as well as international exposure is the SPDR Lehman International Treasury Bond ETF. It's the first ETF to give international bond exposure, with debt from countries like Japan, Germany and Italy. Plus, it is nearly inversely correlated to the U.S. dollar, which gives weary investors yet more protection from sliding greenbacks. Anderson says State Street saw $180 million flow into this fund in the three months since it has been out. Many clients were trying to both diversify their bond portfolio and find protection from a weakening dollar, he says. Anderson adds that with just 18% of the world's sovereign debt issued by the U.S., the debt of other countries is just good portfolio diversification, regardless of the state of the U.S. dollar.

Ptak said he expects 2008 to bring more fixed income funds-munis specifically.

Some in the industry say that the trend of spreading hedge funds to the masses by taking alternative investment strategies mainstream will continue this year.

In 2007, Rydex followed ProShares into the market with ETFs which seek to use leverage and shorting-tactics made popular by hedge fund managers. The bullish funds leverage an investor's exposure to an index by doubling the return of the index, and the bearish funds give an investor the inverse of an index's return. For example, if the S&P 500 climbs 1% on a given day, investors in an ultrabullish fund make 2% that day. If the S&P 500 fell 1%, the investor in a bearish fund would make 1%, while investors in ultrabearish fund would make 2%. Of course, if the market goes in the wrong direction, the investor loses that amount.

In the last quarter of 2007, ProShares continued to offer investors ways to bet against markets. They rolled out more of their Short and UltraShort funds, the newest entries giving investors one times and two times the inverse return of the MSCI EAFE (Europe, Australasia and Far East) Index, as well as the MSCI Emerging Markets Index. It also offered two new UltraShort funds, tracking stock markets in Japan and China.

Michael Sapir, chief executive officer of ProFunds, the parent of ProShares, says his focus in 2008 would be to continue supplying investors with ETFs for shorting and leveraging indices. "There's been a hedge fundization of retail investors' expectations," Sapir says. "Frequently, retail investors are not happy with their financial advisors giving them a static asset allocation pie chart and a set-it-and-forget-it' strategy."

He notes the avalanche of financial press about the success of hedge funds and university endowments using alternative strategies. "Advisors are hearing from their clients that they want a piece of that," Sapir says. "We're giving advisors the ability to create hedge fund-like portfolios by buying ETFs."

Tim Meyer, the ETF business line manager for Rydex Investments, agrees. Meyer says he too has seen a lot of interest from institutional investors and financial advisors for leveraged and inverse ETFs.

Rydex got into leveraged and inverse leveraged funds last year. It now has six of the products in the market and expects to double that number soon.

One wealth manager who uses ETFs extensively to manage his clients' portfolios is Eric Leake, chief investment officer of Anchor Capital, in Irvine, California. Leake has consulted with ETF providers to develop new products, and is an enthusiastic user of alternative ETFs. "I think it's a great trend to get exposure to currencies and commodities... and gain exposure to the yuan and U.S. dollar and Qualcomm and the S&P and gold all in one account," he says. "It's great and needed for the environment we're in. Investors need to be able to profit from trends in more than just equity markets."

Leake is also a big fan of the leverage and short funds, which have expanded beyond broad indices to encompass sectors and styles. He points to the ProShares offerings that allow investors to get two times the inverse of the Russell 1000 Growth and Value Indices. He likes the fact that leveraged funds give investors the ability to allocate less capital to a position and achieve the same result.

For example, if using an ETF that gives two times the performance of a particular sector, the advisor can put down 5% of his client's capital rather than 10%. Then, he can put the remaining 5% elsewhere.

Another trend that appears to have legs in 2008 is what some call "fundamental ETFs," and Ptak calls "quasi-active ETFs," or funds that track an index, but seek to add some extra performance by tracking some kind of proprietary benchmark designed to beat the Russell 2000, or the S&P 500 or the MSCI EAFE. PowerShares and WisdomTree Investments both offer products like this.

The former uses quantitative models to sift and churn the stocks in the portfolio, while WisdomTree weighs stocks in its portfolio by dividends and earnings, rather than by market cap, as do most index-tracking ETFs.

Ptak says these offerings do offer investors a very different choice from "some garden-variety domestic large cap." But he adds, "At a certain point you start to ask if you're getting to the point of saturation."

New Kid on the Block

A new twist on ETFs, whose future looks unclear in 2008, are exchange-traded notes. These products seek to combine the characteristics of bonds and ETFs. With about $4 billion in assets, they are a type ofunsecured, unsubordinated debt. Similar to ETFs and different from other bonds in that their returns are based on a market index, they do not pay coupons like bonds. Like ETFs, ETNs are traded on an exchange, but can be held like a regular bond until maturity. The note promises to make a payment equal to the return of a certain benchmark over a certain amount of time, similar to principal on a bond. Also similar to a bond, the issuer's credit rating can affect the price of an ETN.

They had been popular because of their tax treatment. An investor could buy today and sell three years later with no distributions, unlike most regular bonds. So taxes were deferred until the investor sold, with the difference being a long-term capital gains rate of 15% versus an ordinary income rate that could be up to 35%.

But recently, the Internal Revenue Service ruled that ETNs are debt securities, effectively making them taxable as ordinary income at the time they're sold, triggering a higher tax rate. The IRS also said the accrued interest is taxable. Since an ETN doesn't pay any distribution, it would accrue interest within the note. And investors would have to pay interest on that annually. The IRS ruling applied to ETNs tracking currencies, but the agency is still considering the question of tax treatment for ETNs tracking commodities and stocks. Rydex's Meyer says his firm had been looking into ETNs, but stopped after the ruling.

Better Mousetraps?

Meyer also believes that the steady drumbeat of new products will slow in 2008. "Issuers will be a little more selective to create investment opportunities that are not available today." He adds that issuers will "change from product launches to product support, telling investors how to use these products and how they fit within an investment strategy."

Consider those ETFs which use fundamental factors to select growth and value stocks, rather than simply tracking an existing index. These funds then rank their growth or value stocks based on a system.

Despite the appeal of a better, more intelligent mousetrap, the bulk of ETF assets are still in the traditional cap-weighted products because that's what investors are familiar with, industry watchers say. "At Rydex, our pure style funds are certainly unique and they haven't raised the amount of assets we expected, so we need to educate investors," Meyer says.

One new type of ETF in registration is the first so-called 130-30 fund. Filed by ProShares, this alternative strategy allows a manager to hold 130% of the portfolio long and 30% short. The idea is the extra 30% long equals out the 30% short and the extra exposure to the market is offset. Ideally, the investor has extra exposure to the market, but without the extra risk.

The industry is also keeping a close watch this year on the ongoing effort to engineer an actively-managed ETF. There are a few prototypes currently awaiting SEC approval. The idea is that a fund run by an active manager could be grafted onto the extremely tax-efficient and inexpensive ETF model. If it could be made to work, the actively-managed ETF would tend to be more efficient than a regular mutual fund, because the fund manager would not have to sell shares to meet redemptions, which triggers capital gains in a traditional mutual fund.

The difficulty is that one of the ETF structure's inherent strengths-its transparency, which keeps it liquid and able to track indices closely-could hamstring the manager running the portfolio. By making his or her stock picks known to the market, they lose competitive advantage as others rush to "front-run" the fund-that is, buy or sell ahead of the fund, getting a better price. "The paradox has always been you want an active manager to have the freedom to do their job, which means trade. But you want the market to know what's in the portfolio," says Morningstar's Ptak. In the case of two of the three funds in registration, the compromise is that the manager will only trade on one day-Friday-and will disclose the new portfolio on Monday. And the manager would be limited to three trades. "It's very constrained. It's active in quotes," says Ptak. The third fund in registration has not limited its manager, but is trading in mega-cap shares, a part of the market that is so efficient, the manager need not worry about another investor front-running his or her trades. Ptak adds: "These could be a better mousetrap. It remains to be seen."