Cheap ETFs Are Getting Even Cheaper

"If you undercut us today, be prepared to do it again tomorrow. We won't just lower costs on one or two funds, we will do it across the board." -- Incoming Vanguard chief investment officer Tim Buckley

Them's fightin' words!

Vanguard's new CIO isn't some hotshot fund manager. As Reuters put it, "he has no plans to make big market calls." And yet Vanguard's competitors should be plenty concerned as he's expressed his dedication to beating all comers in the race to be the lowest-cost provider.

In the world of actively managed funds, the juice for asset management companies is offering funds that it can market on savvy managers' outperformance -- or, at least, the promise of outperformance. But when it comes to exchange-traded funds, particularly index ETFs that mirror indices like the S&P 500 (INDEX: ^GSPC  ) , the name of the game is offering the product at the lowest cost possible.

Charles Schwab (Nasdaq: SCHW  ) recognized this and realized if it wanted to make any headway against competitors like Vanguard and BlackRock (NYSE: BLK  ) it'd have to get its fees to limbo nice and low. So Schwab recently reduced the fees on its ETFs, including slashing its Large-Cap Value ETF fee from 0.13% to 0.07%. In conjunction with the fee cut, Schwab CEO Walt Bettinger pointed out:

In this period of uncertainty in the markets, the expenses investors pay are the only sure thing. As a longtime advocate for investors, we want to offer our clients a truly low-cost way to build a diversified portfolio.

BlackRock won't likely be far behind as its management has said lower ETF fees are on the way there as well.

Tough act to follow
Earlier this week, Vanguard showed that its dedication to low fees is more than just words. The manager of $1.7 trillion in investor money said that it's ditching indexes from MSCI in favor of those from FTSE Group in an effort to cut costs further on a group of ETFs and mutual funds with more than $500 billion invested.

But from a bigger-picture view, it will be a very tough for Vanguard's competitors to keep up with it when it comes to low fees. As Vanguard's Craig Stock has put it "Yes, Virginia, we really are client owned." That is, Vanguard's funds are owned by the customers invested in those funds, and the company itself is, in turn, owned by the funds. Unlike Schwab and BlackRock, there are no shareholders that need to be answered to when low fees on ETF products lead to lackluster returns.

The real winner here: you?
Since there are no Vanguard owners that stand to take a big rake if low fees allow it to grab an increasingly large piece of the rapidly growing ETF pie, it's the investing public that stands to win big from this ETF-fee faceoff. While we tend to talk individual stocks a lot at The Motley Fool, we also recognize that for some people, at some times, or for certain parts of your portfolio, a well-chosen index fund can be the very best choice. I personally own shares of three Vanguard ETFs -- Vanguard Dividend Appreciation ETF (NYSE: VIG  ) , Vanguard MSCI EAFE ETF, and Vanguard MSCI Emerging Markets ETF (NYSE: VWO  ) .

Not that you have to be in Vanguard funds to benefit from this. Even if Buckley makes good on his promise to keep cutting fees to stay below competitors, the efforts of Schwab and BlackRock to stay in the game will mean lower fees for investors in their ETFs as well.

Of course, the benefit will only be had by those investors that are focusing on the costs of their investments. Higher-cost, actively managed funds have a tough time delivering for their customers. For the five years ending in 2011, 61% of actively managed funds underperformed their benchmark according to S&P Indices. For 2011 alone, 84% lagged their respective benchmarks. With index-fund and ETF companies tripping over themselves to offer their services for less, it seems (small-f) foolish for fund investors to not be considering these funds.

Motley Fool newsletter services have recommended buying shares of BlackRock. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Vanguard MSCI EAFE ETF, Vanguard MSCI Emerging Markets ETF, and Vanguard Dividend Appreciation ETF, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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