How to Win at the ETF Game

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It's no secret that exchange-traded funds have been the go-to investment in recent years for investors feeling let down by their actively managed mutual funds. There are now more than 1,000 ETFs available to investors, with more funds on the way every day. While the field had been dominated by a few large players that controlled most of the sector's assets, some newer names are quickly gaining market share and highlighting the key to success in ETF land.

Closing in on the leader
According to a recent report by market research firm Cogent Research, Vanguard has surpassed BlackRock's iShares as the top-ranked ETF provider based on advisor loyalty. That means scores of advisors are directing their clients' assets into Vanguard's offerings, boosting its presence on the ETF scene. In fact, among its advisor base, Vanguard's ETF assets under management have more than doubled, from $2.3 million per advisor in 2009 to $5.5 million per advisor today.

The news is particularly interesting when you consider how much of a head start iShares had on the ETF game. According to Morningstar data, the first group of iShares ETFs was launched in 1996, followed by a continuous stream of new funds beginning in 2000. iShares now offers more than 200 funds that cover every major (and most minor!) stock and bond market segment both here and abroad.

Vanguard got a later start to the game, introducing its first two ETFs in 2001. Vanguard didn't add further to its ETF lineup until 2004. The shop now offers 46 exchange-traded funds covering a wide variety of market sectors. But given the early start and market dominance that iShares had in the ETF arena, how has Vanguard managed to chip away at its lead and gain favor in the financial advisory community?

The key to success
While brand loyalty and customer experience have likely played a very big role in Vanguard's growing success in the ETF field, I think there is something even more basic underlying those factors: cost. Vanguard's ETFs are simply some of the cheapest in the business, although upstarts like Charles Schwab are quickly churning out similarly low-priced funds in an attempt to nab market share. Because you're not paying for manager expertise when investing in ETFs, cost is usually the single most important way investors determine success. There's no reason to pay more when it comes to ETF investing.

Consider, for example, the iShares MSCI Emerging Markets ETF (NYSE: EEM  ) , which has a 0.72% annual expense ratio, whereas the Vanguard Emerging Markets Stock ETF (NYSE: VWO  ) is less than half that. Ownership will cost you a mere 0.27% every year. Likewise, the iShares S&P Small Cap 600 ETF (NYSE: IJR  ) will run you 0.20%, while the Vanguard Small Cap ETF (NYSE: VB  ) is a cheaper 0.14%. Vanguard's low prices are surely a big part of what makes them so attractive to advisors and everyday investors alike.

All in the family
If you're an ETF investor, or are looking to expand your holdings in this area, Vanguard is a great place to look for inexpensive funds. In fact, you can pretty much build an entire fully diversified portfolio just with Vanguard ETFs.

To cover the domestic stock market, the Vanguard Total Stock Market ETF (NYSE: VTI  ) is probably your best bet. But because this fund leans more heavily toward the large-cap end of market capitalizations, you'll probably want to pick up a small-cap-focused fund like Vanguard Small Cap ETF.

On the foreign side of things, the Vanguard Europe Pacific ETF (NYSE: VEA  ) will take care of exposure to developed markets. The aforementioned Vanguard Emerging Markets Stock ETF will give you your developing markets allocation.

As far as the fixed-income side of the equation goes, Vanguard Total Bond Market ETF (NYSE: BND  ) should provide wide exposure to the domestic bond market, including Treasuries, mortgage-backed securities, and corporate bonds. Of course, you can expand your portfolio beyond these basic categories, but with just this handful of ETFs you can cover all your major bases, and probably do it cheaper than you could with almost any other fund family.

In the end, I expect Vanguard will continue to win ETF assets at the expense of other providers, thanks in part to its rock-bottom pricing scheme. Take a hint from Vanguard and make cost one of your primary objectives when shopping for exchange-traded funds or other investments.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Amanda Kish is the Fool's resident fund advisor for Rule Your Retirement. At the time of publication, she did not own any of the funds or companies mentioned herein. The Fool owns shares of Vanguard Emerging Markets Stock ETF. The Fool has a disclosure policy.

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