ETFs for Tomorrow

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Index funds have long been a Foolish way to gain instant, low-cost diversification without worrying about timing the market. Their ease and convenience may explain the growing popularity of exchange-traded funds -- mutual funds that trade like stocks. According to the Investment Company Institute, ETF assets totaled more than $596 billion of the more than $1 trillion in stock index funds as of April 30 -- a 28% increase over last year, and up $25 billion from March.

Originally modeled after index funds, ETFs have gradually narrowed to target specialized slices of the market. That's a boon to investors seeking specifically targeted investments, but it also concentrates the risks of specialization and tilts a portfolio away from the diversification that makes index investing attractive.

Today, we're looking at the exchange-traded funds with the lowest expense ratios. The Fool's "60-Second Guide to ETFs" explains:

By construction, ETF investors have less exposure to capital gains taxes than mutual fund shareholders. That's because fund managers frequently buy and sell the fund's holdings -- and ask investors to pick up the tab. ETFs occasionally shift shares, too, although much less than most mutual funds. Annual expenses for ETFs range between 0.1% and 0.65% and are deducted from dividends. Index mutual funds charge anywhere from 0.1% to more than 3%.

We'll combine that information with the collective intelligence of our 110,000 professional and novice investors at Motley Fool CAPS, to see which funds earn our participants' highest ratings.

ETF	Net Assets	Expense Ratio	3-Year Return	CAPS Rating
Vanguard Total Stock Market ETF  (AMEX: VTI)	$10.81 billion	0.07	16.1%	***
Vanguard Large Cap ETF	$1.58 billion	0.07	16.2%	***
SPDRs (AMEX: SPY)	$77.06 billion	0.08	13.5%	NR
Vanguard Extended Market Index ETF	$645.2 million	0.08	22.4%	**
iShares S&P 500 Index	$16.71 billion	0.09	13.5%	*
Vanguard Small Cap ETF (AMEX: VB)	$1.24 billion	0.10	17.9%	*****
Vanguard Value ETF	$2.43 billion	0.10	10.2%	****
Vanguard Growth ETF	$3.75 billion	0.10	21.5%	**
Vanguard REIT Index ETF (AMEX: VNQ)	$2.37 billion	0.10	16.4%	***

Source: WSJ.com. CAPS ratings courtesy of Motley Fool CAPS.

Tread carefully with ETFs, Fools. The market offers many ETFs, but few have a long history. All of the funds we're looking at here report at least a three-year performance record, arguably an important milestone, yet only time will tell whether they can continue building a solid track record over longer time periods.

A strategy that pays dividends
It shouldn't be surprising to find the Vanguard family populating the list of low-cost ETFs. John Bogle has made a career out of low-cost investing strategies, and it's only natural that he would extend that philosophy to his ETF offerings. His top-rated Small Cap ETF offering has also held up quite well in the current economic climate: It has returned nearly 18% over the past three years. CAPS player tradingfool2 thinks it's ready to cycle toward higher growth again:

We're in (or close to) the part of the economic cycle where small cap and growth tend to outperform. Even with large fluctuations over many cycles the overall return of small cap is greater on average. So if my timing is good, the chances are great that this pick will be a good long term play.

Attempting to replicate the MSCI US Small Cap 1750 index, the Vanguard Small Cap ETF holds a broadly diversified group of companies, including online travel website priceline.com (Nasdaq: PCLN), miner Cleveland-Cliffs (NYSE: CLF), and mining-equipment manufacturer Bucyrus International (Nasdaq: BUCY). With worldwide demand still strong for basic materials and commodities, many CAPS All-Star investors believe Bucyrus will be able to sustain its growth trajectory. Says player donktastic:

I really think this is a great company positioned to profit from all mining companies globally. Additionally, their net cash flow from operations almost doubled from Dec. 2006 to Dec. 2007 (actually just over 84%) and their EBIT increased 69% over that same period. There's a good reason this company has outperformed the S&P 500 since September 2007. It's in the numbers. They are taking advantage of the rising price of oil. We should too! I still need to read the Management Discussion & Analysis from the 2007 annual report, but I don't expect to see any red flags.

A basket of opinions
Although ETFs have been around since the 1990s, investors should exercise caution with any ETF lacking a long track record. Over on CAPS, let us know whether you think these ETFs will continue to outperform or whether it's time for new ones to top the lists.