In this volatile market environment, ETFs were the investment vehicle of choice for many institutional investors and advisors, thanks to the funds' intraday trading capability and tax efficiency. Year-to-date through Oct. 31, a period when $113 billion flowed out of mutual funds, ETFs took in $2.6 billion in new assets.

"People are buying ETFs right now because when the stock market is moving 500 points a day, you want to be able to buy when you want—and not have to wait for the end of the day," notes Scott Burns, director of ETF analysis at Morningstar. Investors looking for sector exposure also turned to ETFs, Burns says, as they didn't trust even the most blue chip of companies, given the recent turmoil.

Short-Sighted

Investors continued to short the rocky market throughout 2008, and ETFs were a low-cost, tax-efficient way to do it. Short and leveraged ETFs took in $87 million in assets in just the first two months of the last quarter, and all of the top-performing ETFs were either double-short or ultra-short. Ultrashort Semiconductor Proshares was up a whopping 161% year-to-date through Nov. 30. The flight to quality we've seen since this recession began continued through all four quarters of 2008, bringing $17.3 billion into fixed-income ETFs through Nov. 30. The iShares Lehman 20+, a long-term Treasury, was up 18%.

No long-only equity ETFs saw positive results year-to-date through Nov. 30. Even the usual defensive sectors saw significant losses: Healthcare was down 27.7%, while consumer staples lost 15.2%. Large pharmaceutical companies, typically stalwarts, began to suffer as layoffs and cuts in spending led many consumers to turn to generic forms of their medications.

Financials' Bad Year

But it was the abysmal performance of the financial sector that wins the booby prize for 2008. The worst- performing ETF of the year, as of Nov. 30, was Ultra Financials ProShares, down an appalling 84.36%, while Financial Select Sector SPDR, the 12th largest ETF in existence, lost 55.09%. Surprisingly though, $13.5 billion of assets rushed into these funds through Nov. 30. So what's next in this dramatic story?

"The next affected area will probably be Europe," says Dina Ting, portfolio manager at Barclays Global Investors. "They're a little behind in recognizing the issues and still grappling with working together. The fact that they're not a single country and must coordinate between multiple governments complicates the road to recovery."

As more bad news feeds the market frenzy, investors will be frustrated by most traditional approaches to investing. The tax-efficient creation and redemption process that most ETFs enjoy, as well as the ability to control buy-and-sell prices, have caused many of them to jump into these low-cost baskets of securities.

"Within managed funds, the industry will pay out significant capital gains taxes this year, which will drive people crazy. On the ETF side, you'll basically see nothing," says Dan Dolan, director of wealth management strategies at Select Sector SPDRs. "Most years this goes unnoticed, but this year you're already down 40%. And who do you think clients are going to complain to about more losses? Their advisors, of course!"