The Vanguard Group fired the latest salvo in the exchange-traded fund (ETF) price wars by slashing the annual expense ratios of all but one of its sector offerings to 0.19 percent. Vanguard, which is well known for the rock-bottom expense ratios of its mutual funds, now faces only one other competitor whose ETF expense ratios are priced as cheaply.

Vanguard’s sector ETFs currently boast about $10 billion in assets under management (AUM), a distant second to the $45 billion that State Street Global Advisors manages for its Sector SPDRs. Vanguard clearly hopes to win greater market share in the ETF arena, and its success in winning the battle for bond ETF assets has emboldened the asset manager.

Back in 2003, iShares launched its iShares Barclays Aggregate Bond ETF (NYSE: AGG), one of the first total bond market ETFs to come to market. By virtue of its first-to-market advantage–as well as the fact that the ETF’s expense ratio has been steadily pared over the years to 0.22 percent–iShares Barclays Aggregate Bond ETF has long been the largest bond ETF on the market, with $14.2 billion in assets under management.

But about a month ago, Vanguard Total Bond Market ETF (NYSE: BND) finally surpassed its iShares competitor in AUM, which climbed to $14.6 billion.

Both funds track the Barclays Aggregate US Bond Index and move almost in lockstep, exhibiting a near-perfect correlation. But when comparing the total return of the two ETFs since 2007, Vanguard’s ETF has actually outperformed iShares’ product by more than 150 basis points.

What’s the difference? Vanguard Total Bond Market ETF charges an annual expense ratio of just 0.11 percent versus the 0.22 percent charged by iShares Barclays Aggregate Bond ETF. And over the long term, expenses matter a great deal when it comes to investment performance. Investors recognize that fact and have been allocating their assets accordingly; Vanguard Total Bond Market ETF is winning twice as many new assets as iShares Barclays Aggregate Bond ETF.

With expenses being the only differentiating factor between the two ETFs, lower costs have proved alluring to investors. And Vanguard intends to press that advantage to increase its $173 billion share of the $1 trillion ETF market.

There are two likely reasons underpinning Vanguard’s latest move, both of which involve an increasingly competitive marketplace.

The first reason is that there’s likely to be an almost apocalyptic thinning of the ETF herd this year. This doesn’t have anything to do with an ancient Mayan doomsday prophesy, but the fact that ETF issuers have sliced and diced the investment universe into such narrow niches that many ETFs have failed to attract the necessary assets to make their continued operation economic.

Currently, there are about 350 ETFs on the market that have less than $10 million in AUM and miniscule average daily trading volumes. While not all of those funds will close this year, a substantial portion of them could be folded as a cost-saving move by their sponsors. And costs are becoming a concern for ETF sponsors, with iShares recently cutting 60 jobs in its San Francisco office and 15 in London.

As the ETF herd thins, Vanguard hopes to garner assets from its fallen peers.

The second factor driving Vanguard’s cost cutting is that even as unprofitable ETFs fold, another enormous competitor is entering the market.

For years, Fidelity Investments has largely ignored the ETF market. Indeed, Fidelity NASDAQ Composite Index Tracker (NSDQ: ONEQ) has been its sole offering in this space.

Fidelity is now rethinking that stance and filed with the Securities and Exchange Commission (SEC) on December 1 for permission to launch a raft of new ETFs. The filing, which runs in excess of 100 pages, would, if approved, grant Fidelity wide latitude in the types of ETF products it could launch.

Beyond that, Fidelity asked for permission to use a master-feeder structure in creating the ETFs. This closely resembles Vanguard’s approach, which involves creating ETFs as new share classes of its existing index funds. However, Vanguard has a patent on this unique share-class structure, so the two fund giants may end up battling one another through the legal system as well as the marketplace.

The ETF market will be extraordinarily competitive for ETF sponsors in 2012, but that could ultimately serve investors well if ETF sponsors continue to compete on costs.

What’s New

Thanks both to the holidays and renewed SEC scrutiny of ETFs, there were no new filings last week.