ETFs for Tomorrow

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 $568 billion of the more than $1 trillion in stock index funds as of Jan. 31. That's a 32% increase over last year, but down $39 billion from December.

Originally modeled after index funds, ETFs have gradually narrowed to target specialized slices of the market. While that's a boon to investors seeking specifically targeted investments, it also concentrates the risks of specialization, tilting 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 94,000 professional and novice investors at Motley Fool CAPS, to see which funds earn our participants' highest ratings.

Tread carefully with ETFs, Fools; while the market offers many exchange-traded funds, few have a long history. These, though, all have a three-year performance record, arguably an important milestone. 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 the company's ETF offerings.

You'll hear a common refrain around the Motley Fool: If you can't beat the market, buy the market! For many investors, that's meant buying Vanguard's Total Stock Market Fund (VTSMX). But if you want to do it on the cheap, and if you plan to make big-block, infrequent purchases, buying the Total Stock Market ETF will get you in even cheaper.

A year ago, the industry analysts at NetscribesETF, top-rated All-Star investors at CAPS, cautioned against buying the market because of weakness in the economy:

Given the broad base of the ETF, it more or less emulates the movement of the US economy as a whole. As it owns more small caps in numbers, it may look a bit sluggish in the future if small stocks surrender the market leadership that they've enjoyed in recent past. This could turn out to be a major risk as small caps are not as strong to stand any headwinds in the economic scenario.

However, equally savvy CAPS All-Stars like rlchapman noted even earlier that while the Total Stock Market ETF is at most a breakeven bet if you're only playing it on CAPS -- it is the market, so you can't beat it -- it's a good long-term pick for your own portfolio:

This is a good ETF to get into in real life because of the low costs and other reasons people have mentioned, but it is not a good CAPS pick. Even if it does beat the market long term, it will only be by a hair. Despite picking this to overperform, I would not recommend that anyone else pick it if they are interested in doing well in CAPS. Of course if you are picking it for other reasons, pick on!

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.