Some of the most popular ETFs over the past month could hold nasty surprises for investors.

As Dave Nadig pointed out in his most recent blog, investors spent most of January plowing money into Vanguard’s ETFs. He attributed this in part to investors “getting smart” about ETFs: choosing funds with the lowest expense ratios and strong tracking performance, which in many cases meant Vanguard.

I think that’s part of it. Part of it is also that Vanguard’s ETFs tend to attract steady, buy-and-hold investors: the kinds of investors that plow ahead with their monthly contributions regardless of what’s happening in the market. iShares and State Street Global Advisors ETFs, by contrast, attract significant interest from traders, who are more apt to move money in and out of the market in response to volatility.

Besides, looking at which individual funds attracted the most attention in January, I’m not so sure how “smart” all that new ETF money is.

Consider the single most popular ETF in January: the iShares Barclays TIPS ETF (NYSEArca: TIP). TIP has ridden a wave of inflation paranoia to incredible heights. The fund pulled in nearly $1.2 billion in January, and has more than doubled its assets over the past year, from $9.6 billion to $20.0 billion. It is now the sixth-largest ETF in the world, just a smidge behind the iShares S&P 500 (NYSEArca: IVV) ETF.

Investors buying TIPS (and more specifically, TIP) are (perhaps justifiably) concerned about runaway inflation. There's certainly a theoretical sense to this: With an inflation-indexed bond, the value of the principal is adjusted annually based on changes in the Consumer Price Index.

The equation seems simple: Worried about inflation? Buy Treasury inflation-protected securities, and your principal is protected.

What they don’t realize is that the Federal Reserve will likely raise interest rates well before significant inflation is captured in the official CPI. That's not a complete certainty of course, and some very smart people would disagree with me, suggesting that the Fed will leave interest rates near zero well into a recovery. But my assumption is that rates are headed up, and as rates rise, the value of TIPS bonds (indeed all bonds) will fall. That means TIPS investors will likely feel the pain of rising rates before they feel any benefit from CPI-related inflation adjustments.

The impact of rising rates will fall across the full bond spectrum, but it seems like TIPS investors will feel particularly wronged. They will have made the “right” market call—rising inflation—and yet earned subpar returns.

One of the big risks of ETFs is that they open up new asset classes to investors. That’s great, but it sets up some investors for getting burned.

The headline numbers for fund flows look great, but not for the older players.

All the hubbub this last week was about how much money Fidelity is going to save you by giving you free trades on iShares (see my previous blog, and Matt’s attempt at a rebuttal). But the real news may be that investors have figured out that expense ratios matter, and they’ve been voting with their feet, heading to the low-cost providers. Here’s the league table from the latest NSX report. This is net cash flow for January:

And here’s the other end of the spectrum, the very, very bottom of the winners and losers:

Now, the bottom of the chart is largely explained by Matt’s cryptic blog from January, where he wandered aimlessly around the $13 billion in outflows in the S&P 500 SPDR ETF (NYSEArca: SPY), a cyclical issue we’ll get into in the coming weeks, and which expanded to a net outflow of $16 billion by the end of January.

But beyond that little hiccup, the numbers can be explained very, very easily, and they all point toward investors just getting smart and cost conscious. Let’s look at a few of January’s juicier tidbits:

Can it be any clearer what’s happening here? EEM and VWO have been duking it out in the court of investor opinion for years, and it looks like investors are finally starting to pay attention. EEM, with an expense ratio of 72 basis points and a heavily optimized portfolio, is falling—very fast—to VWO, the Vanguard equivalent that charges just 27 basis points and nearly fully replicates the same underlying index. That difference in approach and price has put VWO investors over 8 percent ahead of EEM investors in the last year. And in this market, 8 percent is a phenomenal difference.

Again, here we see Vanguard with a near-full replication approach, and State Street and iShares duking it out with optimized, more expensive strategies. In this case, BND is only beating the iShares product by 74 basis points over the last year, but is beating the State Street SPDR version of the same index by 1.23 percent. Here the issue isn’t so much cost, as completeness. LAG has an expense ratio of just 13 basis points, extremely competitive with BND’s 14 bps and AGGs 20, but over recent history, the difference between holding a few hundred optimized bonds and thousands and thousands has worked in Vanguard’s favor.

Combine this with the growth of sleepy, underreported funds from Vanguard like the Vanguard Morgan Stanley REIT ETF (NYSEArca: VNQ), up $324 million in January, and the don’t-forget-Canada EAFE killer, the Vanguard FTSE All World ex-US ETF (NYSEArca: VEU), up $332 million, and it’s clear that the old Vanguard formula of “core, complete and cheap” is working in spades.

Is it any wonder iShares is nervous?

Ultimately, this is what’s good for the little guy Matt thinks I care so little about. Investors wising up to where the real values are in the market. No, that doesn’t mean “everything Vanguard,” but in January, it definitely went their direction.

Your argument about Fidelity's new free trading offer, Dave, is clever, insightful, well written … and wrong.

At least, it is for the majority of investors.

In case you missed Dave's blog on Fidelity, it's available here. In essence, Dave argues that Fidelity's move to offer free trading in 25 iShares ETFs is—despite appearances—bad for long-term investors, because it commingles the cost of trading ETFs with the cost of actually running the fund.

It's a sound academic argument. One of the beautiful things about ETFs is that they work well for traders and for investors. When traders move in and out of traditional mutual funds, the funds are forced to buy and sell securities to facilitate that cash flow. That harms long-term shareholders, who bear the costs of commissions and spreads. That's why many mutual funds have short-term redemption fees.

In ETFs, small-scale trading activity does not engender costs to long-term shareholders because it takes place on an exchange. For large transactions, ETFs that use in-kind creations and redemptions (which is to say most ETFs) are protected as well. It's part of the reason ETFs are inherently "fairer" than mutual funds: The costs (as well as the tax consequences) of buying and selling shares is borne by the person who does the buying and selling, not by other shareholders.

Until, according to Dave, now. Dave assumes (correctly, I imagine) that BlackRock is paying Fidelity a fee to subsidize the free trading offer.

"Whatever BlackRock is paying Fidelity to offset trading costs is money that could otherwise be spent to the benefit of long-term investors."

The problem with that argument is twofold: First, it's hypothetical and only looks at one facet of the fee question; second, and more importantly, it overlooks the huge class of investors that this deal helps.

On the first point: There is no reason to believe that BlackRock fees will rise or even decline more slowly under this deal. Price competition is alive and well in the ETF industry. My sense is that the money BlackRock is spending on this effort is considered a "sales & marketing" effort, and if it weren't spending money on this, it would be spending money on advertisements in the Wall Street Journal, Barron's, etc.

The second point is more fundamental. While your argument makes theoretical sense, it ignores the huge class of investors who are excluded from ETFs today by the burden of commissions. For the individual investor with $1,000 or $10,000 or even $50,000 to invest in a portfolio of ETFs, commissions are significant. Many of these investors (rightfully) stay out of ETFs because the commissions would eat them alive. Others, I'm sure, follow suboptimal rebalancing schedules for the same reason.

The Fidelity offering, like the Schwab offering before it, brings these investors into the fold, inviting them to enjoy the benefits ETFs offer, including intraday liquidity, better transparency, inherently lower costs (even with the Fidelity kickback) and vastly superior tax-efficiency.

Of course, you have to look at the all-in costs of your investment; for certain funds, you may be better off paying a commission even if you're a small-scale investor. But for others, these offerings open the door.

So yes, on a theoretical basis and for large, wealthy investors, the Fidelity deal is a bad shake. But for the rest of us, it's good news indeed.

On examination, this silk purse looks more to me like a sow's ear.

We’re fond of thinking we’re the smartest guys in the room, so it’s always good when someone knocks us down a peg. Back in November, when Schwab launched its commission-free ETFs, Matt and I were both skeptical on the podcast. We weren’t skeptical that they’d be successful, and indeed, with $556 million in assets as of today, they’ve clearly found an audience.

Instead, we were skeptical about whether Schwab's move was a harbinger or an outlier. Ultimately, we concluded that Schwab was in a unique position: They didn't need to make money on trading their ETFs, because they could just profit from the management fees. Other brokerage firms—like Fidelity or E*Trade—would have to sacrifice real trading revenues to strike such a deal with a big ETF provider.

The problem is, as it so often is, cash. Such deals aren't unknown. The traditional mutual fund industry was busted apart by Schwab's "OneSource" program back in 1992, which let Schwab customers trade a select list of no-load mutual funds without transaction costs. During the '90s, the program became a dominant feature of the mutual fund landscape—no fund company could hope to compete without either a sales commission or a contract with Schwab.

And those contracts weren't (and aren't) cheap. Fund companies pay Schwab up to 40 basis points to be part of that no-transaction fee business.

40 basis points!

That's more than the total expense ratio of most core ETF holdings, and certainly more than all of a few of the 25 ETFs featured under this deal with Schwab (with a few notable exceptions, like the iShares MSCI Emerging Markets (NYSEArca: EEM) at 72 basis points).

So what is the deal here? Well, it's fairly certain that money's changing hands, and that money is coming directly out of the BlackRock coffers and into the hands of Fidelity. But on what terms?

My guess is that it's a similar deal to the OneSource program—a flat basis point deal. The numbers would have to be much, much smaller, but it's the only situation that makes sense. It's not the only option—Fidelity could believe that offering the core iShares products on a privileged basis will drive assets into other products and trading in other ETFs, but I doubt they’re feeling so generous with their client base as to offer it as a wash.

They could be asking iShares for trading coverage—a few dollars per trade—but that would put perverse incentives in place, where Fidelity would want trading volume and iShares would want assets under management.

Finally, there could be some sort of alternative deal—a flat fee perhaps. But given that the deal has been confirmed as lasting at least three years, everyone concerned has to be looking at the upside, and in this case, upside means assets.

For this perspective, it’s basis points for sure. But how many? 13F filings aren’t really that helpful here, as all the mom-and-pop holders inside Schwab and Fidelity aren’t counted in one clean line item. But it is fair to say that Fidelity probably has a lot of money sitting in iShares ETFs, and this deal represents a reasonably large new source of income for them.

That new revenue stream is coming online at an important time, because in case you missed it, there’s a flat-out price war being waged among discount brokers right now. While “25 Commission-Free iShares” is what made the headlines, the more important news may actually be that Fidelity is lowering its commissions to $7.95 on everything else. That’s the low mark among the big retail discount brokers, and it’s a blow that’s going to hurt the already-hurting discount brokerage business. Schwab, for its part, just reported its worst quarter in recent memory, with negative revenue growth of -18% year-over-year.

While the price war is good news if you’re a hyperactive trader, I believe it’s actually bad news for long-term investors. Whatever BlackRock is paying Fidelity to offset trading costs is money that could otherwise be spent to the benefit of long-term investors. One of the great things about ETFs is that they cleanly segregate trading and investing costs. Unlike mutual funds, ETF investors don’t—until now—suffer any ill effects for their funds being heavily traded.

This move to have trading costs essentially covered by ETF expense ratios just tosses mud on what—up until now—had been a very, very clean lens.

If you’re looking for pie-in-the-sky ETF promises, Dave, you need look no further than your recent blog on the new Wildcat ETF.

In case you missed it, it’s available here.

It’s not that you’re completely off-base about the new Jefferies | TR/J CRB Wildcatters Exploration & Production Equity ETF (NYSEArca: WCAT) ETF. You get the facts right, and you are, as they say in the legal profession, “directionally correct.” But you get your nose so buried in statistics that you overlook common sense, and that’s where you come a cropper.

You write in your conclusion:

The first sentence is absolutely true. Like the junior gold miners ETF from Van Eck, WCAT is essentially a small-cap version of an established and popular large-cap ETF: the First Trust ISE Natural Gas ETF (NYSEArca: FCG).

That makes it useful. People interested in natural gas investing can use WCAT to move up the risk ladder when looking at natural gas equities. The fund should be more volatile and, assuming natural gas prices rise, deliver stronger returns over the long haul. You could even argue that it offers more of a pure-play on natural gas than FCG, since its components are more likely to be pure-play natural gas producers than conglomerated “oil & gas” companies.

But the idea that WCAT is simply a better mousetrap because it’s delivered a better Sharpe ratio over the past five years is short-sighted. The last five years has been an extraordinary period for the commodities industry, which by and large has had a tremendous wind at its back. Five years ago, oil cost less than $40 a barrel and had been sitting there for a number of years.

In a positive environment for commodities, it’s not surprising to me that a small-cap commodity equity index would have better risk-adjusted returns than a large-cap version.

In short, statistics are useful. But sometimes, you can lose the forest for the trees. In this case, the best way to understand WCAT is as a small-cap, more pure-play version of FCG. That could be a great way to go if you’re bullish on natural gas and/or expect a wave of consolidation in the natural gas space.

But the idea that it’s somehow a better mousetrap strikes me as foolish. If commodities take a prolonged step back, the risk inherent in something like WCAT will make itself known.