ETFs for Tomorrow

Investing in index funds can be all the Foolish strategy you need to build a financially rewarding portfolio. You get instant, low-cost diversification across a variety of industries, and you never have to worry about timing the market.

Making automatic contributions into an index fund gives an average investor all the benefits of dollar-cost averaging, making it easy to save regularly for the future. Warren Buffett once noted that his favorite time to sell is "never," and in that respect, index funds let you invest just like the Oracle of Omaha does.

That could explain why exchange-traded funds are so popular. According to the Investment Company Institute, ETF assets totaled more than $507 billion of the more than $1 trillion in stock index funds as of August 2007.

A basket of stocks
ETFs, originally modeled after index funds, are mutual funds that trade like stocks. The first batch of ETFs, known as SPDRs ("spiders"), offered even lower expense ratios than many index funds, along with some additional tax efficiency. The ability to trade ETFs like stocks added to their popularity, although Fools should note that increased taxes and trading costs can erase any benefits from buying and holding an ETF.

As ETFs proliferated, they gradually narrowed their contents, from broad indexes to specialized slices of the market. That's been a boon to investors seeking to home in on certain areas of the market by buying a basket of related stocks. But it also concentrates the risk that accompanies such specialization, tilting a portfolio away from the diversification that makes index investing attractive.

Today, we're looking at the exchange-traded funds that exhibit the lowest expense ratios. As the Fool's 60-Second Guide to ETFs explains, one of the biggest benefits of ETFs is their low cost. As you can see below, several ETFs charge less than 0.1%, and you'll find many with costs below 0.25%. That compares quite favorably with actively managed mutual funds.

So let's check out the cheapest of the cheap.

While there are many ETFs to choose from, few have very long histories. All of these ETFs, however, have at least a three-year performance standard, including the granddaddy of ETFs -- the SPDRs -- that have been around since 1993.

Of course, only time will tell if these ETFs can build as solid a track record over five- and 10-year time periods. Until then, however, investors would be wise to use caution if an ETF of interest has less than three.

In the Vanguard of performance
No one should be particularly surprised to find Vanguard hogging five of the top seven spots on the low-cost leader list. The fund family famous for the low fees charged on its mutual funds also leads the way here with its Total Stock Market ETF, which seeks to measure the performance of all the U.S. common stocks regularly traded on the NYSE, AMEX, and the Nasdaq OTC markets.

CAPS All-Star HoweirdRoark, who has a 97.13 player rating, likes Vanguard's broad market play because of the long-term outlook one should have in investing, and says:

I love ETFs ... I'm a BIG fan. This one will obviously not outperform the S&P by much, but because it factors in the DOW, NASDAQ and S&P I like its chances to slightly outperform. Outstanding long-term play, I actually utilize this ETF in my IRA.

Although the vast majority of the ETF is comprised of stocks in the S&P 500, it holds a broad enough mix of small caps to juice its returns, and that's why CAPS player ganalon thinks it will outperform the market:

Low, low fees, fully-diverse US fund. Enough small caps to edge the SP500.

A basket of opinions
Although ETFs have been around since the 1990s, investors might want to be cautious with any ETF that doesn't have a long track record.

What's your opinion? Let us all know at CAPS on whether you think these ETFs will continue to outperform -- or if it is time for new ones to ascend to the top of the lists.

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