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.