The Key to ETF Success

Exchange-traded funds remain the hottest corner of the investment world. Billions of dollars are flowing into these funds, and firms are falling all over themselves to bring novel ETFs to market. With all the different funds now available, investors should be careful not to overlook the one thing that may have the biggest impact on ETF returns.

Competition heats up
Recent news from Vanguard indicates that the firm will launch an ETF price war against industry maven Barclays Global Investors. Vanguard plans to introduce an exchange-traded fund covering the same market as Barclays' biggest ETF, iShares MSCI EAFE ETF (NYSE:EFA), at a much lower cost. The new Vanguard fund, the Europe Pacific ETF, will track the same index as the iShares offering, but its 0.15% expense ratio will be less than half that of the iShares ETF.

It's easy to see why Vanguard is taking aim at this particular fund. iShares' MSCI EAFE fund is the industry's second-largest ETF, with more than $45 billion in assets. This move follows Vanguard's introduction earlier this year of its Total Bond Market Index ETF (AMEX:BND), which charges 0.11% in expenses, compared to 0.24% for the comparable iShares Lehman Aggregate ETF (AMEX:AGG).

The key to success
Vanguard has rightly hit on one of the most important attributes an exchange-traded fund can possess: low expenses. In ETFs or regular index mutual funds, one of the best predictors of good performance is the fund's expense ratio. When funds aren't actively managed, you're not paying for a stock picker's expertise in outguessing the market. Therefore, you shouldn't have to endure excessive fees. With all the index funds and ETFs attempting to track the S&P 500 Index, why not choose the one that charges you the least to do so?

The lack of active management means the marketplace doesn't tolerate high fees for index funds or ETFs, though investors may pay more for more actively managed funds. Check out the following average expense ratios for funds in the Morningstar database:

Clearly, much of the benefit of owning either an index fund or ETF is their lower expense relative to actively managed funds. However, even among index funds and ETFs, expenses vary widely:

The funds listed above should also tell you something about the relative cost of broader-market funds and ETFs compared to more narrow, specialized funds. The smaller the slice of the market, the more you'll likely pay for the associated fund. Recent evidence shows that as new ETFs become increasingly specialized, the average expense ratio for all ETFs is creeping up.

Keeping expenses lean
If you're in the market for an exchange-traded fund, look first at how much management will charge you to own it. Typically, funds that maintain rock-bottom expenses will have just enough of an edge to beat out those bogged down by higher costs. There's no need to buy pricey ETFs that focus on narrow market segments -- think broad, and think cheap.

As firms such as Vanguard and Barclays continue to duke it out for dominance in the ETF arena, costs will likely continue to fall across the board. That should be a good thing -- for both investors and the ETF market in general.

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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. The Fool's disclosure policy covers everyone, and charges nothing.