For a while now I have promoted instruments like the First Trust Revere-ISE Natural Gas Index ETF(FCG) and the JPMorgan Alerian MLP Index ETN(AMJ) as the best ways to play the expanding U.S. natural gas industry.

Thanks to the advent and development of unconventional natural gas drilling techniques, analysts now estimate that the natural gas reserves in the U.S. could adequately supply the nation for a century.

However, despite the optimistic forecast for this fuel source, there remain a number of critics, many of whom are concerned over the detrimental effects natural gas production can have on the United States’ water sources.

The hydraulic fracking method of natural gas extraction involves the pumping of water and chemicals deep underground in an effort to break up the underlying shale, allowing natural gas to escape.

Although many natural gas companies insist the depths these producers are drilling are far below levels where consumable water is extracted, many remain concerned about the long-term negative implications this process could have on water, which is essential for crops, livestock and citizens.

The ongoing debate between natural gas proponents and environmentalists highlights the important, albeit often overlooked, potable water industry. Because there is little chance that natural gas is going to go away any time soon, something is going to have to be done to ensure that we continue to have adequate access to drinkable water well into the future.

Fortunately, today there are a number of companies like Nalco(NLC), Veolia(VE) and Itron(ITRI) that focus on preserving our water supply. Even Warren Buffett has a hand in this industry. According to the most recent Berkshire Hathaway(BRK.A) 13-F filing, the Oracle of Omaha has amassed a significant position in Nalco.

ETF investors looking for access to this important industry have a number of plays to consider.

Today, four ETFs provide investors with pure-play exposure to companies both domestic and abroad that are working to ensure that the world’s population has access to adequate sources of water.

Investors looking for exposure to U.S.-listed water companies should turn to the First Trust ISE Water Index Fund(FIW) or the PowerShares Water Resources Portfolio(PHO). Both of these instruments boast an equal-weighted index. Both charge a 0.60% expense ratio, and FIW has outperformed in 2010. However, FIW’s volume is on the low side, and most investors should stick with the more liquid PHO.

Investors desiring a more geographically diverse water portfolio should look to the Claymore S&P Global Water Index ETF(CGW) or the PowerShares Global Water Resources Portfolio(PIO). Although the U.S. makes up the largest single geographic slice of both funds, these ETFs also boast exposure to companies hailing from countries such as Canada, Japan and Europe.

Because of their international exposure, these two instruments carry higher fees: 0.65% for CGW and 0.75% for PIO. This year, having access to international water players has not paid off. Both CGW and PIO have consistently underperformed their domestically focused cousins.

Ultimately, I would advise investors looking for a play on water to stick with the strong, liquid PHO.

Investors are moving cash back into the stock market, but they don’t know where to put it yet. Plain vanilla index funds saw some of the largest net inflows in February. Of the top 10 ETF inflows, four were broad domestic indexes: SPDR S&P 500 (SPY), PowerShares QQQ (QQQQ), iShares Russell 2000 (IWM) and iShares S&P 500 (IVV).

Two of the top 10 were bond funds: iShares Barclays 1-3 Year Treasuries (SHY) and iShares Barclays TIPS (TIP). There’s still widespread concern about inflation, as TIPS and short-term bonds are two ways to defend against rising interest rates.

Although Vanguard MSCI Emerging Markets (VWO) had the second-largest inflows last month, it is because the fund continues to attract investors from iShares MSCI Emerging Markets (EEM) due to superior performance and lower fees. VWO saw $1.149 billion in net inflows, while EEM saw $2.444 billion in net outflows, the largest outflows of any ETF in February. Overall, investors were net sellers of emerging markets.

The other three-largest inflows went to ProShares UltraShort S&P 500 (SDS), Industrial Select Sector SPDR (XLI) and Consumer Staples Select Sector SPDR (XLP).

The flows into SDS are remarkable in that this fund saw assets increase about 17% in February, to a hefty $3.488 billion. That’s a large sum for a leveraged ETF; SDS is now almost twice the size of the next largest leveraged equity ETF, the ProShares Ultra Financials (UYG). Both XLI and XLP have been outperforming in 2010 and investors may be looking for these trends to continue.

Besides the huge outflows from EEM, investors also exited iShares FTSE/Xinhua China 25 (FXI) and iShares Latin America 40 (ILF). They also sold SPDR Barclays International Treasury (BWX) and Market Vectors Gold Miners (GDX). All of these ETFs are losing their attractiveness due to a higher U.S. dollar, which posed a strong headwind on these sectors.

Investors also piled out of U.S. Natural Gas (UNG) and U.S. Oil (USO) as well. UNG was one of the most popular funds in 2009, but investors may have finally tired of betting on this perennially losing sector. However, since the outflows in USO are similar, it’s more likely that an institutional investor may have moved out of these funds.

Although not a top 10 outflow, PowerShares DB U.S. Dollar Index Bullish Fund (UUP) saw significant outflows of $176 million, or nearly 10% of assets, and a similar amount has already flowed out in March, based on the latest figures from the PowerShares Web site.

Despite the money headed out of the international and commodity ETFs, investors sent small amounts into some currency and commodity ETFs. WisdomTree Dreyfus Emerging Currency (CEW), Market Vectors Junior Gold Miners(GDXJ) and WisdomTree Dreyfus Chinese Yuan (CYB) saw inflows of more than $100 million.

Some investors ignored sovereign debt crises in Europe and the tumbling euro, as net inflows into CurrencyShares Euro (FXE) reached $81 million. That number was almost exactly matched by euro bears, however, who poured $78 million into ProShares UltraShort Euro (EUO). Given that EUO offer is two times the daily inverse of the change in the euro vs. the U.S. dollar, the net effect is bearish sentiment on the euro.

It appears that many dollar bulls have shifted to euro bearish. Since UUP only offers about 58% exposure to the euro, and it has been the main driver of the fund, it makes sense that aggressive investors would head for the leveraged euro ETF. Also, the funds flowing into CEW and CYB show that it’s the euro that is weak, rather than the dollar strong.

Finally, in terms of performance chasing, the biotechnology sector saw money flow into two funds: SPDR S&P Biotech (XBI) and First Trust NYSE Arca Biotechnology (FBT). XBI pulled in more total dollars, but FBT, which has been the better performer in 2010, attracted about half as much money, even though it was only about one-fifth the size at the end of January.

PowerShares Dynamic Biotech & Genome (PBE) outperformed XBI, but still saw net outflows, as did the largest and worst-performing biotech ETF, iShares Nasdaq Biotechnology (IBB).

Overall, the net flows into biotechnology are too small to be blamed for this year’s run-up to date, and much of the move has been acquisition and news related. This suggests biotech’s rally could be closer to its beginning than its end.

Disclaimer

The media sector, which includes the film industry, has reason to celebrate as well. So far in 2010, the representative ETF, PowerShares Dynamic Media Portfolio(PBS), is outperforming the broader markets.

Year to date, the fund is up by 10.7% compared to a 2.5% gain for the S&P 500 Index as represented in SPDRs(SPY), 1.5% for the Nasdaq as tracked by PowerSharesQQQ(QQQQ), and 1.6% for the Dow Jones Industrial Average as represented Diamonds Trust Series 1(DIA).

Unlike the broader markets, PBS was not derailed significantly by the news of China’s credit-tightening policies after Jan. 19. During the market dip that occurred after that time, PBS spent far fewer days beneath its 50-day moving average than SPY, QQQQ, or DIA. Furthermore, PBS’s 50-day moving average trend line did not even retreat from its upward sloping performance, while the slopes of the trend lines for SPY, QQQQ, and DIA, turned negative.

What made PBS resilient to the action in the broader markets and will it continue to outperform?

I see that PBS’s outperformance certainly has not been driven by its top holding, Google(GOOG), which accounts for 5.0% of the fund and has shed 9.0% year to date.

Also, although the rest of the PBS’ top-five holdings, Disney(DIS), News Corp(NWS), Time Warner(TWX), and Comcast(CMCSA) outperformed the broader markets year to date, they did not outperform PBS.

However, it’s important to note that PBS applies a relatively equal weighting to each of its 30 holdings and that the smallest allocation of net assets such as Sirius(SIRI), which accounts for 2.4% of holdings, can drive the fund’s performance.

SIRI was one of the holdings in PBS that drove the fund’s outperformance of the markets as the stock has jumped by 57.3% year to date. Other holdings with strong performances were E.W. Scripps(SSP), HSN(HSNI), McClatchy(MNI), Valassis Communications(VCI), and Entercom Communications(ETM), which increased by 39.4%, 38.2%, 45.2%, 55.8%, and 70.6% respectively.

Although some of these are not top-10 holdings in PBS, they collectively account for 17.3% of the fund’s holdings.

In the case of SSP, a newspaper company with diversified media operations, strong earnings drove shares higher. MNI, another newspaper operator had its credit ratings upgraded by Moody’s and S&P in February since the company’s debt burden, which had harmed shares of the company last year, is becoming more manageable.

HSNI, the television shopping company, had stronger-than-expected earnings and a positive outlook that drove up shares. ETM, a radio company, also went up after it reported a return to profit in its earnings.

On the other hand, VCI, a mail-marketing company, did not impress investors with its earnings in late February. Although shares dropped sharply following the news, they quickly reversed and continued marching higher, a sign of deeper strength in this sector.

All in all, the fuel behind these stocks and the sector is something that will continue to burn going forward. The media sector, which thrives on advertising, will have an improving outlook as economic recovery frees up more money for the advertising budgets of companies.

In terms of performance, PBS fell further than the broader markets during the crisis and outperformed during the recovery. On a two-year timeline, PBS has outperformed SPY, but has not yet surpassed QQQQ. Because many of the companies in PBS trade on the Nasdaq is room for this fund to outperform.

Disclaimer

In the following three blogs from the past week Don advised investors not to give up on a certain natural gas ETF, said to go with gold ETFs that are physically backed by the precious metal and commented on investing in the Internet revolution.

I Won’t Give Up on FCG
Posted 03/05/2010 7:48 a.m. EST

Both the United States Natural Gas ETF(UNG) and the First Trust ISE-Revere Natural Gas ETF(FCG) moved lower this afternoon as investors digested the government’s latest natural gas supply data. As of 3:30pm, FCG had dropped 2.11%, while UNG had fallen more than 3.8%.

Supplies of natural gas may not be dropping as quickly as expected, but FCG’s going to be a hard habit to break — and I’m not sure I’m ready yet.

Since I first recommended FCG last June, I’m sure that more than one of you has gotten sick of hearing about this particular basket U.S. of companies involved in the exploration and production of natural gas.

I’ll admit it: My initial passion for FCG was partially fueled by my dislike for UNG. I’ve certainly beat that ETF’s problems to death, but, suffice to say, I was disillusioned even before UNG started selling futures contracts to buy stocks.

I like the feeling of knowing that FCG tracks real, live U.S. natural gas firms, not a basket of derivatives.

(Disclaimer: I have been recommending AMJ, which is debt instrument comprising master limited partnerships. I still think the advantages of this product for income far outweigh the risks of the ETN structure.)

Over the past eight months, however, I’ve come to appreciate the elegance of FCG’s equal-weighted methodology. This fund provides exposure to 31 natural gas firms (using four different screens to eliminate the crazies) and never puts all your eggs in one basket.

Since I first recommended FCG as an alternative, I’ve spent a lot of your time bashing UNG. For every time I’ve stripped apart UNG’s strategy, however, I’ve taken time to appreciate the potential of the real-life U.S. natural gas firms that FCG tracks. FCG has renewed my faith in the natural gas sector, in drilling technology, in shale…

It hasn’t hurt that FCG’s gone up 29% since Jun. 18, 2009 while UNG has fallen nearly 77%.

I still think the U.S. natural gas companies look strong. It’s not time to give up on FCG yet.

Stand By Your Gold ETF
Posted 03/03/2010 11:01 a.m. EST

Long-term investors in gold ETFs backed by physical holdings of the precious metal should stick to their guns, despite recent net outflows.

Recently released 13-F filings from December show that everyone, from George Soros to Harvard’s endowment fund, was investing in gold late last year. Even sovereign wealth fund China Investment Corp. admitted it was a sizeable holder of the SPDR Gold Shares ETF(GLD)  in a recent report.

While these filings may reassure investors looking to scoop up shares of a bullion-backed fund, such as GLD, iShares Comex Gold(IAU)  or the new ETFS Gold Trust(SGOL), a more accurate picture of interest in GLD comes from recently released fund data. Yesterday, the National Stock Exchange released February 2010 ETF fund flows, and GLD saw net asset outflows of $161 million. Even more interesting, GLD had $937 million in net asset outflows so far in 2010, after netting more than $7.3 billion in assets during 2009. This may indicate that, by the time we get to read 13-F filings from famous investors and institutions, many of them may have already reversed course.

However, when you’re talking about a fund such as GLD, which I have recommended to investors for the long term, it’s better to avoid the noise. When the 13-F filings were released last month, I urged investors to ignore the hype and buy GLD for the right reasons. I still believe in this message, despite news of the net outflows.

Not all physically-backed precious metals funds were dinged in February. SGOL netted $11 million in assets last month, while its newly launched sister-fund, ETFS Physical Platinum Shares ETF(PPLT), bagged $60 million in net assets.

While gold investments are particularly difficult — some investors will remember Krugerrands from the 1980s — ETFs such as GLD offer solid, long-term exposure to gold for a diversified portfolio.

Revolutionary Trade
Posted 03/01/2010 03:17 p.m. EST

We’re enjoying a golden age of the data-driven Internet, and it’s not too late to get on board.

This Internet revolution is unlike the last. While investors wildly speculated about how much tech companies were worth during the Internet bubble, no one has to speculate anymore about how ingrained companies like Google (GOOG), Yahoo!(YHOO) and Amazon(AMZN) are in American culture.

Just think of the daily activities now shaped by the Internet:

* Want to buy a stock? Use an online broker like TD Ameritrade (AMTD) or E*Trade (ETFC). The floor of the NYSE looks desolate in the wake of an online brokerage revolution.

* Traveling? Search for tickets at Priceline (PCLN) or Expedia (EXPE). Have you noticed how many people are bypassing lines at the airport by printing out their paid-in-advance tickets online?

* Release your inner hypochondriac — or investigate your stuffy nose — using WebMD’s (WBMD) database. (Who can afford health care anyway?)

Other than revolutionizing every corner of the marketplace, what do all of these companies have in common? Each one is a component of the First Trust Dow Jones Internet Index ETF (FDN). FDN is up more than 2.5% today, and this portfolio still has room to run.

The best investments are the ones that you notice blooming around you — the ones you don’t need an expert to see or explain. FDN’s portfolio is full of companies that you use every day in every part of your life.

Disclaimer

Winners

First Trust NYSE Arca Biotechnology Index Fund(FBT) +12.4%

SPDR S&P Biotechnology(XBI) +4.8%

PowerShares Dynamic Biotechnology & Genome Portfolio(PBE) +6.8%

Biotech ETFs showed strength throughout this week largely thanks to buyout news. The biggest spike came Monday when both Millipore(MIL) and OSI Pharmaceuticals(OSIP) made M&A headlines.

Merck KGaA, in an effort to improve its position in the industry, agreed to buy out Millipore, offering the firm more than $7 billion. Astellas Pharma made a $3.5 billion hostile takeover bid for OSI Pharmaceuticals.

Sequenom(SQNM) also jumped, after a Cantor Fitzgerald analyst upgraded the company’s shares to buy from hold, while InterMune(ITMN) rallied on Friday when the market reacted positively to an FDA review of the firm’s drug for a fatal lung disease.

Market Vectors Steel ETF(SLX) +8.9%

SLX rallied as iron ore price negotiations between top producers and Asian steelmakers continued this week. Currently, the talks are leaning strongly in favor of top ore producers like Rio Tinto(RTP) and Vale(VALE) which, if successful, could see an 80% hike in prices. This would be the second largest price increase in history and help pave the way for industry expansion.

Russian Steel giant Mechel aided SLX’s strong performance this week when shares surged on news that the company had received a loan extension from Gazprombank, which extended $1 billion of loans to six years from three.

ETFS Physical Palladium Shares(PALL) +10.3%

Solid February sales numbers from the U.S.’ Big Three auto makers helped power PALL higher, making it the top performing precious metal this week. Palladium and its cousin platinum typically rise in step with automobile demand because they are essential metals used in the production of catalytic converters.

Losers

United States Natural Gas Fund(UNG) -4.0%

iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN(GAZ) -4.8%

Natural gas futures slumped to a three-month low on news that inventories dipped less than predicted. As expected ETFs designed to track the price of this fuel, including the infamous UNG, were dragged along for the ride. I have consistently warned investors that this fund is dangerous. Living up to my warnings, it managed to hit record lows this week.

While commodity-backed natural gas plays suffered this week, FCG and AMJ, which track natural gas via the companies that explore, develop, transport and store the fuel, managed to stay in the black.

iPath Dow Jones-UBS Grains Subindex Total Return ETN(JJG) -3.0%

PowerShares DB Agriculture Fund(DBA) -1.7%

Sinking grain prices weighed heavily on commodity backed agriculture ETFs like JJG and DBA this week. Futures prices saw a drop thanks to a strengthening dollar and a more optimistic weather forecast for major growing regions including the Midwest and South America.

CurrencyShares British Pound Sterling Trust(FXB) -0.7%

The pound got punished this week for a variety of factors. At the start of the week I mentioned two headwinds that have weighed on the currency’s strength over the past few days.

For one, it was announced on Monday that U.K.-based Prudential(PUK) had offered AIG(AIG) more than $35 billion for its Asian life insurance business, AIA. This cash-heavy deal will involve selling pounds in exchange for dollars.

Secondly, investors have begun to worry about the U.K.’s ability to rein in its growing debt. With elections coming up, the Conservative Party, which investors see as more apt to employ fiscal discipline, has seen its once-impressive lead over the Labor party cut significantly.

Disclaimer

Jobs data out this morning was grounds for another sell-off, but again shares marched higher. The jobless rate in America rose to 7.6 percent as nearly 600,000 jobs were eliminated in January, consistent with the previous two months. As the Bureau of Labor Statistics pointed out, 3.6 million jobs have been lost since December 2007, but nearly half came in the previous three months. The U.S. is on pace for a loss of 7 million jobs in 2009, enough to lift the unemployment rate to around 12 percent.

The implications for the retail, consumer goods, consumer service, and housing sectors are going unexplored today, however, as investors look forward to a stimulus package and to the bank bailout details due Monday from the Obama administration. Shares of financials spiked higher today, with Bank of America up more than 22 percent in morning trading and Citigroup up 10 percent.

On January 28, the S&P 500 Index closed at 874 before sliding back into its trading range; it’s back over 860 today. Technicians will be looking for a higher high either today or sometime next week, and if we get it, perhaps a more significant rally will take place.

Last week I discussed a new position, ETF Market Opportunity fund (ETFOX) that I was adding to most client accounts. It continues to perform well, and as we rebalance your accounts moving forward, I expect this fund will become a larger holding among other growth positions. You can find a more detailed discussion of this fund and an interview with its manager, Paul Frank, in this month’s newsletter that will arrive in the next few days.

Disclaimer

Of the BRICs, the country that gets to most attention is China, and today, I want to show investors one more option they have for international exposure that comes from just outside of China on the country’s doorstep in Southeast Asia.

iShares MSCI Thailand Investable Market Index Fund(THD)

THD tracks 85 Thai companies, trades with ample volume, and carries a 0.65% expense ratio.

The fund’s top holding is PTT Plc, Thailand’s state-owned oil and natural gas company, which accounts for 11.1% of THD’s net assets. Another 9.2% is allocated to the company’s affiliate, PTT Exploration and Production Plc, which handles petroleum exploration operations.

Bangkok Bank is the second largest holding, and the financial sector is the best represented sector in THD, accounting for 36.4% of the fund. The energy sector is close behind, with 31.8% of THD’s net assets. The next largest sector, materials, accounts for only 8% of the fund.

Year to date, THD has increased 2.4% and has beaten a variety of China-focused ETFs in the process.

iShares FTSE/Xinhua China 25 Index(FXI) is down 5% year to date; Claymore/AlphaShares China Real Estate(TAO) is off 4.1%; Claymore/AlphaShares China All Cap(YAO) has fallen 3.7%; and PowerShares Golden Dragon Halter USX China(PGJ) has slid1.5%. Meanwhile, Claymore/AlphaShares China Small Cap(HAO) is up only 0.2%.

Thailand also gained attention amongst investors last week when THD made my coveted weekly list of ETF winners after its five-day gain of 3.9%.

At the close of last week, there was some concern that a Supreme Court ruling to take away a large portion of the corrupt former prime minister’s assets would hurt markets there, but THD has performed well this week and the political scene appears stable for now. UBS also believes that with the ruling out of the way and no immediate negative public reaction, markets will be given further room to run, according to Bloomberg.

Thailand features the cheapest equity market in Asia right now and foreign buyers looking for value helped push THD upwards last week. This trend seems set to continue as Tuesday saw enormous inflows to the country from foreign investors.

The trend may even pick up pace since State Street Global Advisors this week mentioned Thailand as a promising emerging market and cited the cheap valuation of their equity market as part of their reasoning.

In addition inflation in Thailand is under control, falling between January and February and taking pressure off of the government to raise interest rates at the March 10 meeting of policy-makers.

This is important because the government wants the ability to gradually raise interest rates. Although the economy exited the recession last quarter, political unrest could destabilize the economic situation.

Investors should be wary that political protests in Thailand may occur going forward, but they should also keep in mind that troubles in the country have been ongoing for several years and are to an extent factored in to current market values.

The Wrap-Up

THD represents another great opportunity in addition to the Malaysia and Indonesia ETFs I previously mentioned for investors to diversify within the outperforming Southeast Asian region.

Disclaimer

At 20 pages, the discussion was deep, detailed and riddled with his trademark humor. However, at the close of the missive, a number of issues remained untouched.

While some may gripe about the lack of insight into Buffett’s feeling about his Goldman Sachs(GS) investment or his mindset leading to his decision to dramatically cut his positions in oil majors ConocoPhillips(COP) and Exxon Mobil(XOM), perhaps the most pressing issue unaddressed in Buffett’s tome was the company’s plan of succession upon the financier’s inevitable exit. He is 79 years old.

For years, one of the biggest questions on Wall Street has been who will be the leader of Berkshire Hathaway 2.0? Buffett, further aiding to the speculation, has insisted that the decision has already been made.

Unfortunately for curious individuals looking for specifics, the Oracle reportedly keeps the name of his heir apparent sealed in an envelope, stored in his Omaha, Neb. office.

With no hard clues from Buffett himself, investors have been left to speculate over who will take the reigns. Today, many predict that the daunting responsibility of penning the next chapter of Buffett’s life’s work will rest on none other than David Sokol.

For most of his tenure working under the Berkshire Hathaway umbrella, Sokol has led Berkshire Hathaway’s utility branch, MidAmerican Energy Holdings. However, in the second half of 2009, Buffett added to his workload when he put him in charge of NetJets, the struggling subsidiary of Berkshire Hathaway, after the abrupt resignation of Richard Santulli, former CEO and founder of the jet-sharing company.

Thus far, Sokol’s performance at this new post has been positive. Buffett praised his work in last week’s shareholder letter, saying there has been a comforting decrease in the debt and that the firm is on the path to see a return to profit in 2010.

Sokol’s work as the head of NetJets and MidAmerican are not the only examples of his business savvy. He, and Buffett’s long time business partner Charlie Munger influenced Buffett to invest in BYD, the Chinese electric car company, a move that has reaped more than a billion dollars for the financier.
Sokol and Buffett also share a number of non-Berkshire related similarities. They both hail from Nebraska and as The Wall Street Journal pointed out, their early resumes include a number of parallels as well.

Despite being favored by a number of Buffett watchers, Sokol himself refuses to comment on the gossip. Questioned on the topic in a 2009 interview, Sokol insisted that there were a dozen or more executives working for Berkshire more qualified than he was. He went on to say that that type of speculation was a waste of time.

Upon his exit from Berkshire Hathaway, Buffett will leave behind a massive pair of shoes to fill. Though time will tell who will be chosen to take the reins, Sokol appears to be one of the most likely candidates for the job.

Disclaimer

Vanguard made these changes to make the funds more tax friendly and to make them more closely track their respective indices.

Before the switch, Vanguard’s sector ETFs and mutual funds tracked traditional MSCI sector indices, which weigh individual companies from their respective sectors based purely on stock market values.

Although this is the most efficient way to ensure that the indices provide the most realistic view of the actual makeup of the market, using them to create ETFs raises red flags with the IRS.

To prevent a fund from becoming too heavily weighted in a small number of holdings, the IRS has implemented a number of diversification rules that ETF and mutual fund providers must comply with in order to qualify for favorable tax treatment. Failure to meet these requirements results in double taxation.

In order to be meet these diversification standards, any individual fund constituent cannot account for more than 25% of the ETF or mutual fund’s total portfolio, and no more than 50% of a fund’s total index can be represented by individual holdings that each account for more than 5% of the fund’s total index.

These rules pose a problem for Vanguard’s ETFs that are designed to track individual sectors through the MSCI indices.

In a number of instances, a market slice is largely dominated by a small number of companies. For example, the lion’s share of the U.S. telecommunications industry is made up of AT&T(T) and Verizon(VZ).

Therefore, an index like the MSCI US Investable Market Telecommunication Services, which underlies the Vanguard Telecommunication Services ETF(VOX) and the Vanguard Telecommunication Services Index Fund (VTCAX), has a lot more than 25% of its portfolio allocated to each of these two companies.

Unfortunately, due to the IRS’ stipulations, VOX and VTCAX cannot simply copy this index. Rather, the two instruments are forced to alter their holdings by underweighting large companies like AT&T and Verizon and overweighting smaller holdings. This ultimately leads to large tracking errors that undermine the transparent nature of ETFs.

The importance of keeping tracking error to the minimum is highlighted by Vanguard’s success with its emerging-market ETF.

Over the past few months, investors have been fleeing from the iShares MSCI Emerging Markets Index Fund(EEM) and pouring into the Vanguard Emerging Markets ETF(VWO).

These two instruments track the same index: the MSCI Emerging Market Index. At first, one would assume that comparing these funds would be akin to comparing apples to apples. However, if one delves deeper into the inner workings of the two funds, it becomes apparent why investors choose one over the other.

Although each of these funds seeks to track the performance of the same index, each does so differently. The EEM uses a sampling process, leading to the construction of a fund consisting of 439 of the more than 700 constituents in the MSCI Emerging Market Index.

VWO, on the other hand, tracks more than 800 positions, making it even more diverse than the index.

By tracking a sampled version of the index, EEM’s performance at times will not always mimic the index.

Year to date through March 3, VWO’s more comprehensive approach to tracking its index has paid off. Not only has the fund seen massive investor inflows, but it has managed to outperform EEM, which is down -2.1% compared with EEM’s 3.3% drop. The MSCI Emerging Market Index is down 2.3% over the same period.

Seeing the success of VWO, it’s no wonder that Vanguard has taken an important step to fix the tracking error issues facing its sector focused instruments while meeting the requirements of the IRS. The funds now track brand new underlying indices.

Rather than tracking the traditional versions of the MSCI indices, Vanguard’s sector funds now track MSCI 25/50 indices, which meet the IRS requirements.

Though all of the company’s sector-specific index funds and their respective mutual funds will take on these new indices, only a few are expected to see any significant weighting changes.

Aside from the VOX and VTCAX, the funds that will see the biggest changes due to the index alterations will be those tracking the MSCI US Investable Market Energy Index (which include the Vanguard Energy ETF(VDE) and the Vanguard Energy Index Fund (VENAX)) and the funds backed by the MSCI US Investable Market Consumer Staples Index (which include the Vanguard Consumer Staples ETF(VDC) and the Vanguard Consumer Staples Index Fund (VCSAX)).

John Bogle is Vanguard’s founder and is known as the father of index mutual funds. He has long insisted that his firm take a shareholder-first approach, and the recent adjustments to the sector funds reflect this attitude.

By employing these new indices for its sector-specific funds, the company not only protects itself from breaking IRS rules; it also ensures that investors are provided with instruments that closely track their indices. In this case, both parties come out winners.

Disclaimer

Many ETF investors, however, may be wondering whether now is a good time to ring the cash register on their gold funds or initiate new positions in the metal.

Gold has gained attention and accessibility as an investment option via ETFs, and the metal is valued because of its usefulness as a portfolio diversifier and its ability to outperform the stock market for long periods at a time.

In 2009, gold prices rose 24%, while they remain essentially unchanged since the start of 2010. As gold trades sideways, investors are left deciding whether now is the time to cash out, sell short, or buy long. Before looking at the outlook and strategy, let’s go over the best fund choices.

In 2010, the most popularly traded gold ETF is still SPDR Gold Shares(GLD), a physically backed fund that is up 2% year to date. GLD is a great way to hop on the gold bandwagon and investors who do so are in good company with current holders such as investor George Soros, hedge fund Paulson and Co., and China’s sovereign wealth fund.

Another popular physically backed option is iShares COMEX Gold Trust(IAU), which has the same 0.4% expense ratio as GLD and is also up 2% year to date. Less popular, but still very liquid and featuring a slightly lower expense ratio is the ETFS Physical Swiss Gold Shares(SGOL).

There is also the Sprott Physical Gold Trust(PHYS), which was launched last Friday and trades at about one tenth the price of IAU, GLD, or SGOL, making it appealing to smaller investors. The expense ratio is capped at 0.65%, which is higher than the other three gold funds, and the PHYS prospectus touts potential tax benefits for U.S. investors in the fund.

As an alternative to physically backed gold ETFs, investors can use gold-miner ETFs that feature companies like Barrick(ABX), Newmont(NEM), AngloGold Ashanti(AU) and Goldcorp(GG).

MarketVectors Gold Miners ETF(GDX) and MarketVectors Junior Gold Miners ETF(GDXJ) have outperformed GLD and IAU during upward trends in gold prices, but have underperformed in downward trends, and are a more volatile play on gold prices.

If investors want volatility in their gold investments, there are many leveraged funds. Two of the more popular and liquid ones are the PowerShares DB Gold Double Long ETN(DGP), and the PowerShares DB Gold Double Short(DZZ).

Leveraged funds are best for shorter investment time-frames, but long investors should also take into account their investment time-frame when they develop their strategies.

For instance, in the mid-term, the World Gold Council expects that as economies continue to improve worldwide in 2010, demand for jewelry will pick up along with incomes and consumer spending. Jewelry consumption accounted for 52% of total world demand for gold in 2009. However, in 2009, jewelry demand was only 80% of 2008 jewelry demand and 73% of that demand in 2007 demand.

Also, industrial demand for the metal will increase as business picks up for companies that rely on gold. Like jewelry demand, industrial demand is still below its pre-recession numbers and will provide steadily increasing price support for gold.

Furthermore, World Gold Council data shows that the rise in gold prices in 2009 was not brought about by the investment activity of ETF investors or other traders after the first quarter. As a result, the price of gold in the mid-term is not at risk of dropping due to any sort of speculative bubble popping.

In the short term, however, investors should keep in mind that the price of gold has generally maintained an inverse correlation with the U.S. dollar. If the dollar continues to gain against the euro, this will put downward pressure on gold. Investors who had been holding gold as a hedge against inflation will become less inclined to bet on a dollar downfall while the currency is thriving.

However, some of this downward pressure on the price of gold from a falling euro may be offset as investors in the euro-zone and Greece in particular look to the metal as a safe-haven for their wealth. Demand from panicked Europeans may pick up especially if other larger euro countries, such as Spain, come under scrutiny because of their government debt.

In the long term, gold may continue to rise in value as governments worldwide accrue debt and erode the value of their currencies with spending for economic stimulus. Many analysts say this long term trend will lead to the continued appreciation of gold against paper currencies. For instance, gold has appreciated by at least 10% per annum in the past decade against every major currency.

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